26—Lever #2: Taxes (Part Four—Your Marginal Tax Rate)
Your tax life is on the margins
Your marginal tax rate is one of the most critical aspects of our tax system to understand. You may remember that your average (a.k.a. “effective”) tax rate is generally much lower than your marginal rate. One reason is that your top marginal tax rate applies only to a portion of your taxable income; the rest is taxed at lower rates.
That’s the main reason the marginal rate is so important. To illustrate, I’ll expand on the previous examples and assume that Single Filer (yes, that’s his name) is now part of a two-income married household. Congrats, Single!
Let's also assume that the newly married Filers have a combined income of $100,000 instead of $60,000. How does this change their tax liability? More income means more in taxes, but there is more to it than that.
Mr. and Mrs. Filer intend to file a joint tax return. As we did for Mr. Filer, we must first calculate the Filers’ combined AGI and taxable income:
Next, we’ll calculate their adjusted gross income (AGI), which is their gross income (from above) minus specific "above the line" adjustments:
With their AGI number, we'll make this simple and use the standard deduction to calculate taxable income.
Here are the standard deduction amounts for 2025 based on filing status:
Single Filers: $15,000
Married Filing Jointly: $30,000
Heads of Household: $22,500
Using married filing jointly: $86,950 – $30,00 = $56,950.
The Filers have a taxable income of $56,950 on gross income of $100,150 and AGI of $86,950.
Here are the 2025 tax brackets for a married couple filing jointly:
10% for incomes up to $23,850
12% for incomes between $23,851 and $96,950
22% for incomes over $96,951 up to $206,700
24% for incomes over $206,701 up to $394,600
32% for incomes over $394,601 up to $628,300
35% for incomes over $628,301 up to $1,001,600
37% for incomes over $1,001,600.
Their combined tax will be higher than Mr. Filer’s because they made more money together, but the good news is their taxable income has not pushed them into the next higher bracket—it is still being taxed at 10% up to $23,850 and at 12% for all above that.
This graphic shows that their total tax is $6,357, and the average tax rate is 6.3% on $100,150.
But let’s say they each receive a $25,000 bonus, which increases their taxable income by $50,000 to $106,950. This changes things:
Our progressive tax system means with that increase in income, they will jump from a 12% marginal bracket to a 22% marginal bracket. This is not insignificant because it means that for each additional dollar they earn, assuming there are no further deductions or credits, they will be taxed at 22% instead of 12% until their taxable income reaches $206,700. The first dollar beyond that will be taxed at 24%.
We have not factored state taxes into either of our examples, so if this couple lives in a state with a flat income tax rate of 5%, their new marginal tax rate is 22% + 5% = 27%.
To further illustrate why this marginal rate matters, let's return to our income adjustments and increase their 401(k) contributions by $2,000 each ($4,000 total).
You may now see that their taxes will be reduced by an amount equal to their marginal rate (22%) times their $4,000 increase in deductible 401(k) contributions (.22 x $4,000) = $880. That means that the real cost of their additional $4,000 401(k) contribution is $3,120.
And when we also consider the 5% state marginal rate, the $2,000 extra Traditional 401k contribution would have reduced the couple's total tax burden by an additional $200 (.05 x $4,000), reducing the cost of their contribution to $2,920.
Calculating the change in tax liability as the marginal tax rate multiplied by either the change in income or Traditional 401k withholdings is usually sufficient; however, this shortcut does not always work.
An increase or decrease in taxable income could put the couple into a new marginal bracket. In our example, the couple would only need to make about $10,000 less or have deductions of $10,000 or more to be back in the 12% marginal bracket.
On the other hand, they'd have to earn a ton more to go from the 22% bracket to the 24% bracket. (I think they'd take that without complaining too much about a 2% jump in their marginal tax.)
Current marginal tax rates are some of the lowest in history. To find top brackets that were not in the 30s, you have to look back to the 1980s. The table below shows that they can change and probably will. Congress establishes them by law, and the one enacted in 2017, which took effect in 2018, expires this year. It remains to be seen what the current Congress will decide, but it’s very possible that they won’t be higher.
As you can see in the graphic below, most of our tax dollars go to fund healthcare, with an increasing percentage going toward Medicare and Social Security. Since 1980, those budget categories have grown more than the others. The government funds the lion’s share of this spending with payroll taxes (Social Security and Medicare) and personal and corporate income taxes. It makes up the shortfall by selling bonds, a/k/a the “federal debt.”
Frankly, imagining a future scenario without increased taxes is hard. It seems necessary to deal with our growing debt. But raising taxes, especially for the middle class, is politically very unpopular, so we’ll see.
If you've followed everything up to this point, I don't want to puff you up with tax pride (pride goeth before an audit), but you now know more about our tax code than about 90% of others your age. Most importantly, I hope you are starting to understand how this knowledge can help you improve your Financial Life Equation (FLE).
From here, we'll get into some good stuff: We'll discuss the different types of accounts that can hold your savings and investments and their relative tax advantages.
For reflection: We’re all in the same boat; we all (well, most of us) have to pay some tax, but we don’t have to pay any more than the law requires. Would you be willing to pay more taxes to lower the federal debt? Or would you prefer to see massive cuts in government spending instead? In many ways, the government’s finances are like ours: income and spending are the two sides of the debt equation. If income > spending, that’s good; income < spending means borrowing, which increases our debt.
Verse: “The rich rules over the poor, and the borrower is the slave of the lender” (Proverbs 22:7, ESV).