Taxable Income, Tax Brackets, Marginal Tax Rates

By | February 18, 2015

The biggest point of confusion for a tax novice is how the tax brackets affect their tax burden. Your marginal tax rate and your effective tax rate are not the same thing. Moving into a higher marginal tax bracket does not mean your entire income is taxed at that rate.


Marginal Tax Brackets for 2014

The marginal tax brackets for 2013 are listed here (2014). I will use the single filing brackets for illustrative purposes (I also didn’t include deductions for this initial example).

Say you’re a single filer that has $34,000 in taxable income (taxable income is explained more in-depth later). Your boss calls you in and tells you that you’re getting a raise to $40,000 per year! Great! But… how does this affect your taxes? At $34k you’re just under the cutoff for the 25% tax bracket, and now your marginal tax rate is 25% after the raise. Are you really “making” more money, but losing virtually all of it to the increased tax burden?


What are the marginal tax brackets for 2014

No. Since the tax brackets are marginal, based on the marginal tax rate (the tax rate at which the next dollar you earn is taxed), only the amount above the 25% bracket threshold ($36,901) is taxed at 25%. Your tax calculation looks like this:

  • $8,925 at 10% = $892.50 ($8,925 in taxable income)
  • $27,325 at 15% = $4098.75 ($36,250 – $8,925 in taxable income)
  • $3,750 at 25% = $937.50 ($40,000 – $36,250 in taxable income)
  • Total tax = $5,928.75, effective federal rate = 14.8%

The marginal tax rates only apply to taxable income – that is, your income after all of your deductions and exemptions are factored into your total income. Your total income is listed in line 22 of the 1040 form, while your taxable income is listed in line 43 of the 1040.


Deductions: Standard, Itemized, above the line

Everyone is entitled to deduct certain things from their taxes. Deductions reduce the amount of income that is subject to tax – they reduce your taxable income. Deductions fall into three major categories: the standard deduction, itemized deductions, and “above the line” deductions.

  • The standard deduction in 2013 is $6,100 for single filers in tax year 2013 ($6,200 for 2014). If you claim the standard deduction, this is what you’d put in line 40 of Form 1040.
  • If you want to claim itemized deductions, of which a number of expenses qualify, you need to include Schedule A with your tax filing. The total of your itemized deductions goes in line 40 of the 1040 form. The major itemized deductions are for home mortgage interest, state/local/property taxes, and charitable donations.
  • “Above the line” deductions are listed in lines 23-35 of the 1040. Most require additional documentation to show eligibility. In/r/personalfinance the most popular tend to be the student loan interest deduction (line 33) and the IRA deduction (line 32).

One of the most common tax questions we get here is “Should I itemize my deductions or just take the standard deduction?” If the sum of your itemized deductions is not larger than the standard deduction, you’re almost always better off claiming the standard deduction.


Taking the Standard Deduction

Now let’s go back to our simple example from before. Taking into account the standard deduction and one personal exemption for a single filer, the tax calculation changes significantly for the better:

  • $6,100 + $3,900 = $10,000 subtracted from your taxable income.
  • $8,925 at 10% = $892.50 ($8,925 in taxable income)
  • $21,075 at 15% = $3,161.25 ($30,000 – $8,925 in taxable income)
  • Total tax = $4,053.75, effective federal rate = 10.1%

Notice that the standard deduction and personal exemption put you in the 15% marginal tax bracket instead of the 25% bracket.

Your state may offer its own tax deductions for state taxes. Details vary by state, but one of the most valuable is the deduction for 529 plan contributions if your state offers it.