Marginal Tax

Marginal tax rates can be used to compare strategies while effective tax rates can be used to compare taxpayers.

Effective tax rate is the average rate a taxpayer income is taxed. It is calculated by dividing the tax expense by the taxable income.

Marginal tax rates are helpful in determining whether the client should do IRA withdrawal, annuity investment, Roth conversion, and more. Instead of just looking at the average of your tax, marginal tax rates enable the client to see what his next dollar of earning will be taxed at and plan accordingly. Thus, if the client is on the border between two tax brackets, he can calculate what an extra earning of $1000 would be taxed at. He can break down his taxable income to individual transactions and see their tax liability/benefit.

To illustrate, I will use an IRA withdrawal example.

Let’s say I have a retired client, and he is in the 25% bracket this year. If he plans to take out an IRA withdrawal for a $1000 of income this year, he will incur additional $250 of taxes. However, if next year, since he is retired, he will be under the 15% tax bracket, an IRA withdrawal of $1000 will produce only $150 of tax liability. In this case, our client will be better off if he waits for the 2nd year to withdraw his money.

As a tax consultant, I want my client to see how his actions might change his taxable income and his total tax expense. Therefore, I will use the marginal tax rate.