What is a Marginal Tax Bracket

I have a done tax returns for over 30 years now and marginal tax brackets have become very intuitive for me and others who prepare tax returns, but I think we sometimes forget that many farmers and other taxpayers really do not understand how marginal tax brackets work.

Essentially, as your income moves higher, your income tax bracket will move higher at various steps along the way.  Below is a table showing most of the tax brackets for 2015:

In the column for Married Joint Filers, note that if your income is between 0 and $18,450, you will owe tax at a 10% rate.  From $18,450 to $74,900, you will owe tax on this income at 15%.  This means that your first $18,450 will be taxed at 10% and your next $56,450 will be taxed at 15%.

Many taxpayers mistakenly assume that once they hit $18,451 that all of their income is taxed at 15% and once they hit $74,901, then all would be taxed at 25%.  This is not correct.  Only the amount of income that falls within those “brackets” are taxed at those rates.  As you move to the next bucket, you take the “full” bracket amount from the last marginal rate and add in your current tax that falls in your current bracket.

As an example, assume you are a married farmer with $70,000 of taxable income.  Your first $18,450 is taxed at 10% or $1,845.  Your next $51,550 is taxed at 15% or $7,732.  We then add these two numbers together to arrive at total tax of $9,577 or an average rate of 13.68%.  Many taxpayers would assume the total tax to be $70,000 times 15% or $10,500.  The marginal tax system saves them about $1,000 in this example.

So remember, moving into a higher tax bracket just subjects that “marginal” income to the higher rate, not all of your income.

One additional note.  Capital gains and qualified dividends are taxed at wider marginal tax rates.  If any of the capital gains falls into the 15% or lower regular tax bracket, these gains are taxed at zero.  If they fall in the 25%, 28%, 33% or 35% tax brackets, the capital gains are taxed at 15%.  Finally, if any of the capital gains are in the 39.6% top tax bracket, they are taxed at 20%.  Again, these are marginal rates and here is an example.

Assume a farmer sells some land for a $1 million long-term capital gain.  His other net taxable income is exactly zero.  Therefore, he and his wife will pay zero capital gains on the first $74,900; they will pay 15% on the capital gain between $74,900 and $464,850; and 20% on the amount of gain over this amount.  Therefore, the total capital gains tax will be $58,492.50 (the 15% portion) plus $107,030 (the 20% portion) or a total of $165,522.50.  This equals an average capital gains tax rate of 16.55%, but it is composed of three separate tax rates.

Paul Neiffer, CPA