Legal Definitions - Marginal Tax Rate

The Marginal Tax Rate refers to the tax rate applied to an additional dollar of income earned. In a tax system that uses marginal rates, different portions of a person's income are taxed at different percentages, based on predefined income ranges called "tax brackets." This system is designed to be progressive, meaning that individuals with higher incomes typically pay a greater percentage of their overall income in taxes compared to those with lower incomes.

It's important to understand that the marginal tax rate does not apply to all of a person's income. Instead, it only applies to the income that falls within a specific tax bracket. As an individual's income increases and crosses into a higher tax bracket, only the portion of their income within that new, higher bracket is taxed at the higher rate, while income in lower brackets remains taxed at their respective lower rates.

Here are some examples to illustrate how the Marginal Tax Rate works:

• Example 1: Receiving a Bonus

  Imagine a federal tax system where the income bracket from $40,000 to $85,000 is taxed at a 22% marginal rate. Sarah earns an annual salary of $60,000. If Sarah receives a $5,000 bonus, that entire bonus will be added to her existing income. Since her total income ($60,000 + $5,000 = $65,000) still falls within the $40,000-$85,000 bracket, the Marginal Tax Rate of 22% will apply to the full $5,000 bonus. This means she would owe $1,100 in taxes on that specific bonus income, even though other parts of her income might have been taxed at lower rates.

• Example 2: Getting a Raise and Moving into a Higher Bracket

  Consider a simplified tax structure with the following brackets:

  • Up to $10,000: 10%
  • $10,001 to $40,000: 15%
  • $40,001 to $85,000: 20%
  • $85,001 and above: 25%

  David currently earns $80,000 per year. His income is taxed progressively: the first $10,000 at 10%, the next $30,000 (up to $40,000) at 15%, and the remaining $40,000 (from $40,001 to $80,000) at 20%. If David receives a raise that increases his annual salary to $90,000, his Marginal Tax Rate will change for the portion of his new income that falls into the highest bracket. The first $5,000 of his raise (bringing him from $80,000 to $85,000) will still be taxed at the 20% marginal rate. However, the remaining $5,000 of his raise (from $85,001 to $90,000) will be taxed at the 25% marginal rate, as it falls into the highest income bracket. This demonstrates that only the income within the new, higher bracket is subject to that bracket's rate, not his entire salary.