Recently, I had an email exchange with one of my readers at MoneyNing, discussing the advantages of contributing to a 401(k) for most individuals. I emphasized that the entire contribution to a 401(k) is deducted at the participant’s marginal tax rate, while withdrawals are typically taxed at their effective tax rate post-retirement. This discrepancy, though subtle, holds significant importance.
Upon retirement, individuals no longer receive regular income and instead rely on their retirement savings as a source of income. Initially, withdrawals are taxed at a 10% rate if no other income sources exist. Subsequently, if the withdrawal exceeds the limit of the 10% tax bracket, the succeeding portions are taxed at higher brackets, and so forth.
Following this discussion, the reader inquired, “What is a marginal tax rate?” It’s a valid question.
So, What is a Marginal Tax Rate?
I probably shouldn’t have presumed he understood that term. It’s a common misconception; many individuals express concerns about earning more money because they fear being pushed into a higher tax bracket, mistakenly believing they’ll end up with a lower take-home pay due to increased taxes on their raise. However, this assumption is incorrect. Let me clarify.
Your marginal tax rate signifies the percentage of income tax you’ll pay on each additional dollar you earn. For instance, if your marginal tax rate is 24%, you’ll owe the government 24 cents for every extra dollar you make.
The United States, along with numerous other countries like Canada, South Africa, and China, operates on a progressive tax system. This means that as your income rises, so does your tax rate. It’s these misconceptions about the progressive tax system that often confuse people. However, in reality, earning more almost always results in taking home more money.
Here’s An Example
Let’s consider a scenario where you earned $40,000 in 2020. As a single individual residing in Nevada (where there’s no state income tax), and disregarding any tax deductions or Social Security contributions, the initial $9,875 of your income is taxed at a rate of 10%. This means you owe $987.50 on that portion of your income. Given the progressive nature of our tax system, any income beyond that threshold is subject to a higher tax rate.
Income ranging from $9,875.01 to $40,000 (a total of $30,125) is taxed at a 12% rate. This amounts to an additional $3,615. Combining these figures, your total tax liability stands at $4,602.50 ($987.50 + $3,615).
Adding Another Wrinkle
Now, let’s consider a scenario where you heed my advice to start a side gig. Earning extra income sounds appealing, especially when you have skills to offer as a freelancer in graphic design. However, you’re concerned about potentially earning less due to higher taxes as your income increases. The next tax bracket starts with income exceeding $40,126 and is taxed at a higher rate of 22%. Despite this, should you abandon the idea?
Absolutely not!
While the progressive tax system does entail a larger portion of your income going to taxes as you earn more, you still retain the majority of your side gig earnings. Trusting my advice, you decide to persevere. After diligent work, you earn an additional $5,000. Now, let’s assess the impact on your tax liability.
Previously, you owed $4,602.50 on $40,000 of income. With an additional $5,000, your total income becomes $45,000. Beyond the initial $40,000, the first $125 of the $5,000 extra income is taxed at the 12% rate, while the remainder is subject to the 22% rate. After calculations, your total tax liability for this $5,000 increase in income amounts to $1,087.50.
More Income Doesn’t Equal Less Money
So, if your income reaches $45,000, your total tax liability would amount to $5,690. It’s important to note that this calculation doesn’t consider any potential deductions you may qualify for. Surprisingly, if your income is only $45,000, you may find that your tax burden is relatively low. However, delving into tax deductions is a topic for another discussion.
What’s crucial to understand is the net income you retain. Earning $40,000 leaves you with $35,397.50, whereas earning $45,000 leaves you with $39,310.00. Yes, despite paying more in taxes and moving into a higher tax bracket.
In our example, your marginal tax bracket is 12% initially. However, with the addition of a side hustle, it jumps to 22%. It’s a common misconception to believe that your entire income will be taxed at 22%. As illustrated in our examples, only the additional income exceeding $40,000 is taxed at 22%, not your entire income.
A Word on Effective Tax Rate
While discussing marginal tax rates, it’s important to understand effective tax rates as well. Your effective tax rate is simply determined by dividing your total tax liability by your total income. In our example, for the $40,000 income, the effective tax rate is approximately 11.51% ($40,000 divided by $4,602.50). Similarly, for the individual with the side hustle, the effective tax rate is slightly higher at 12.64%.
These figures are far more reassuring compared to the intimidating 22% marginal tax rate. Moreover, once you factor in potential tax deductions, the situation improves even further. While deductions vary among individuals, someone earning $50,000 annually in the United States is likely paying less than 10% in taxes, assuming they have no state tax obligations.
In Conclusion
Our tax system is undeniably complex, offering numerous legal avenues to reduce tax burdens. However, sacrificing additional income solely to minimize taxes shouldn’t be a primary strategy. In reality, the bulk of any extra earnings typically remain in our pockets, despite higher tax rates on income beyond certain thresholds.
If you’re disheartened by a seemingly high marginal tax rate, consider calculating your effective tax rate instead. More often than not, you’ll discover that your actual tax burden is substantially lower than initially perceived.