The Basics of a Marginal Tax Rate
By Gary Parsons
As we emerge, hopefully unscathed, from tax season and turn our attention to the impending political theatrics, tax rates will once again take center stage. Through all the attacks and misinformation we are likely to encounter, it is helpful to establish a basic understanding of what the tax rates actually mean to you. I have found that there are a couple misconceptions about marginal tax rates.
This is not in any way intended to be tax advice, but rather a simple level setting about how income taxes work. Note, for purposes of today’s discussion, the effects of deductions, donations, capital gains and other adjustments to your personal tax rate are out of scope.
First, you often hear people talk about others who do not pay any taxes. This simply isn’t the case outside of tax fraud or “under the table” earnings. Just because an individual receives a full refund of their federal income tax, it doesn’t mean that they avoided employee withholdings, such as Social Security and Medicare, state or local taxes or sales taxes. The reality is that taxes are ubiquitous and everyone in society pays some share of the tax burden, though high earners do shoulder the lions share.
The second major misconception I have encountered is the mechanics of a marginal tax rate. There is a belief by some that if you earn more money all of your income is taxed at a higher rate and therefore it discourages you to continue working. Again, this is simply not the case. Your tax bracket is not the tax rate you pay on all of your income, but rather refers to the amount you pay on the highest dollars earned.
The tax system is purposefully progressive. Whether you make $500,000 a year or $50,000 we all pay the same tax rate on that first $50,000. So, in 2016 for single filers that would be 10% on the first $9,275, 15% on the income between $9,275 to $37,650 and 25% on the income between $37,650 to $50,000. You will notice that as you make more money your tax burden increases with the basic justification being that you can afford to pay more as you make more.
This increase continues all the way up to 39.6% for earnings over $415,050. So, if someone says they are in the highest tax bracket of 39.6%, that doesn’t mean they pay a 39.6% tax rate on all of their earnings, it means they pay that rate on their earnings in excess of $415,050. Whether or not such a rate discourages you from continuing to work and earn is a personal decision, but the fact remains that the system is not so punitive as to subject all of your earnings to that rate just because you are a high earner.
For historical context, prior to the Economic Recover Tax Act (ERTA) of 1981, the highest marginal tax rate was 70%. ERTA was enacted to reduce that tax rate to 50% over three years, which is still much higher than today’s top rate.
In summary, is it a bummer to pay nearly 40% on your earnings over $415,050? I’m sure it is. But, fortunately the way the tax code is written at least it doesn’t impact all of your earnings and 99% of the country will never know what it feels like to have that problem.
This article is meant to be general in nature and is not intended, and should not be construed as personal financial advice. Waddell & Reed does not offer tax or legal advice. The services of an appropriate professional should be sought regarding your individual situation. Gary Parsons is a Financial Advisor with Waddell & Reed and can be reached at 850.894.9950. Waddell & Reed, Inc., Member SIPC (05/16)
