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Here are five examples -- using fictitious but representative taxpayers -- to illustrate how marginal tax rates affect the earnings of Americans.

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How Marginal Tax Rates Hit Taxpayers

Here are five examples — using fictitious but representative taxpayers — to illustrate how marginal tax rates affect the earnings of Americans.

Here are five examples — using fictitious but representative taxpayers — to illustrate how marginal tax rates affect the earnings of Americans.

Example #1
Mary Jones is a single mother with two children. She earns $20,000 a year working in an office. A secretarial course will boost her salary by $2,000 to $22,000. How much of the additional $2,000 will Mary get to keep, and how much will be taken in higher taxes, after all taxes and credits are taken into account?

At $20,000 in income, Mary normally gets an income tax refund of $3,689.54 due to her eligibility for two child credits and the earned income tax credit (EITC). She pays $1,530 in payroll taxes and $1,000 in state income tax. Her net income is $21,168.54.

Her extra $2,000 will fall in the 10% income tax bracket, increasing her basic income tax by $200, which will reduce her net refund by that amount. The extra salary will also cost Mary $421.20 of her EITC. The extra income is also subject to the employee’s half of the payroll tax, which will rise by $153. She will also pay more state income tax, which we assume will be at a flat rate of 5% in her state, or an additional $100. Her additional $2,000 of earnings will boost her net income, after taxes and credits, by only $1,125.80, to $23,294.34, for a combined marginal tax rate of 43.71% on the additional $2,000.

Effective Marginal Tax Rate: 43.71%

Old after-tax income
$21,168.54
Added income
$2,000.00
Added income tax (@ 10% marginal fed. income tax rate)
-$200.00
Drop in EITC (@ 21.06% phase-out rate)
-$421.20
Added payroll tax (@ 7.65%, employee share)
-$153.00
Added state tax (@ 5% marginal rate)
-$100.00
Net gain in income (effective marginal rate 43.71%)
=$1,125.80
New after-tax income
$22,294.34

Note too that her employer will have to pay an additional $153 in payroll taxes on top of the $2,000 salary increase.

Example #2
Bob and Carol Johnson have just finished putting the last of their children through college, and now want to build up a retirement nest egg. Bob earns $62,000 a year as an electrical engineer. Carol works part-time, earning $10,000 a year doing bookkeeping for a local insurance agency. If she continues to work, how much of her earnings can the couple keep, after taxes, to enable them to fund new Roth IRAs?

Without Carol’s income, the couple would have $62,000 before taxes, would pay $14,495.50 in federal and state income and federal payroll taxes, and net $47,504.50 after taxes.

With Carol’s $10,000 in wages the couple has $72,000 in adjusted gross income. Some of the Johnson’s income is exempt from federal income tax; some is taxed at 10% in the lowest income tax bracket; some is taxed at 15%. But the added income that Carol brings in is subject to tax where Bob’s leaves off, putting all of her wages in the 27% tax bracket, costing her $2,700 in federal income tax. She must also pay additional payroll tax of $765 and additional state income tax of $500. Her added tax bill totals $3,965, for a marginal tax burden of 39.65%. The couple’s after-tax income rises by $6,035, to $53,539.50. Carol keeps barely 60 cents of each added dollar she earns. High marginal tax rates on the second earner in a family are one reason why second workers are less attached to the labor force than primary earners

Effective Marginal Tax Rate: 39.65%

Old after-tax income
$47,504.50
Added income
$10,000.00
Added income tax (@ 27% marginal fed. income tax rate)
-$2,700.00
Added payroll tax (@ 7.65%, employee share)
-$765.00
Added state tax (@ 5% marginal rate)
-$500.00
Net gain in income (effective marginal rate 39.65%)
=$6,035.00
New after-tax income
$53,539.50

Note too that her company is also paying $765 in payroll taxes on Carol’s $10,000 salary.

Example #3
George and Martha Wilson have twins just starting college. That is reason enough for both parents to work. George earns $60,000 as part of a group dental practice. Martha earns $30,000 teaching at the local high school. She has been offered an additional $1,000 to supervise the drama club. How much of the additional $1,000 will she get to keep, after taxes?

The Wilsons can use the federal HOPE scholarship credit to save a bit in taxes for their children’s first two years in college. However, eligibility for the HOPE credit is phased out at a rate of 7.5% (per child) as adjusted gross income rises from $80,000 to $100,000. Because their income is in the phase-out range, they will lose 15 cents of credit for each additional dollar they earn.

The couple now earns $90,000 before taxes. Before credits, they owe $9,852 in federal income tax, plus payroll and state income taxes that bring the tax total to $21,237. The HOPE credits reduce their federal income tax by $1,950, resulting in total taxes of $19,287. Their after-tax income is $70,713.

The Wilson’s are in the 27% federal income tax bracket. Martha’s extra $1,000 would be hit by an additional $396.50 in federal and state income and payroll taxes. The couple would also lose $150 in HOPE tax credits. The total tax increase would be $546.50, a marginal tax rate of 54.65%. The couple’s tax burden would rise to $19,833.50. Their after-tax income would rise to $71,166.50. Martha would keep only $453.50 for her added work. She has decided not to volunteer.

Effective Marginal Tax Rate: 54.65%

Old after-tax income
$70,713.00
Added income
$1,000.00
Added income tax (@ 27% marginal fed. income tax rate)
-$270.00
Added payroll tax (@ 7.65%, employee share)
-$76.50
Added state tax (@ 5% marginal rate)
-$50.00
Loss of HOPE Credit (@ 7.5% times 2 students)
-$150.00
Net gain in income (effective marginal rate 54.65%)
=$453.50
New after-tax income
$71,166.50

Note too that her employer will have to pay an additional $76.50 in payroll taxes on top of the $1,000 salary increase.

Example #4
The Olsons are a semi-retired couple, age 63. They have pension and savings income of $40,000 a year. They are receiving Social Security benefits of $22,000 a year. Mr. Olson, a former journalist, still works one day a week for the local newspaper for $6,000 a year. He is careful not to earn more than $11,520 a year, above which (for 2003) he would begin to lose 50 cents of his Social Security benefits for each additional dollar of wages (an implicit add-on 50% tax rate!). Last year, his part-time work brought in $6,000. The Olsons’s total income is $68,000. The newspaper has offered him a $1,000 raise to encourage him to continue working. How much of that raise would he keep after taxes?

Up to half of Social Security benefits (tier one) start to become taxable when “modified adjusted gross income” (MAGI) exceeds $32,000 for a married couple ($25,000 for a single retiree), and up to 85% (tier two) become taxable when MAGI exceeds $44,000 for a couple ($35,000 for a single retiree). For this calculation, the Olsons’s MAGI (= pension and savings income, wages, tax exempt interest, and half of Social Security benefits) equals $57,000. That exceeds the upper threshold for taxation of benefits, so the Olsons must add 85 cents in benefits to taxable income for each additional dollar of wages or income from saving.

Because of the phase-in of taxation of Social Security benefits, an added dollar of wages would cause Mr. Olson’s taxable income to go up by $1.85, and his income tax to rise by 49.95 cents. The Olsons’s 27% federal marginal income tax rate effectively became 49.95%. Their effective state income tax rate would rise as well if their state uses the federal definition of taxable income (not all do). The added wages are subject to the payroll tax, too. The Olsons’s combined marginal tax rate would be 66.85%. The Olsons’s taxes on their initial $68,000 of income total $10,210, netting them $57,790 after tax. If Mr. Olson earns an additional $1,000, their taxes will rise by $668.50. They will keep only $331.50 of the additional income, netting them $58,021.50. Mr. Olson has asked the newspaper to double his raise.

If Mr. Olson had earned more than the earnings limit, his total combined marginal tax rate (federal and state income tax, payroll tax, and loss of benefits due to the earnings test) would have exceeded 100%!

If the Olsons had less income, perhaps $20,000 in pension and savings income, reducing their MAGI, their marginal tax rate would be lower. They would be in the 15% federal tax bracket, and they would have to add only 50 cents in benefits to taxable income for each dollar over the lower threshold. Their 15% federal income tax rate would become an effective 22.5% rate (1.5 times 15). Their state tax rate would increase less too. Their total effective marginal tax rate would be 37.65%. They would keep $623.50 of the additional $1,000.

Effective Marginal Tax Rate: 66.85%

Old after-tax income
$57,790.00
Added wage income
$1,000.00
Taxable Social Security
+$850.00
Added taxable income
=$1,850.00
Added wage income
$1,000.00
Added income tax (@ 27% on $1,850)
-$499.50
Added payroll tax (@ 7.65% of $1,000)
-$76.50
Added state tax (@ 5% on $1,850)
-$92.50
Net gain in income (effective marginal rate 66.85%)
=$332.50
New after-tax income
$58,121.50

Note too that his employer will have to pay an additional $76.50 in payroll taxes on top of the $1,000 salary increase.

Example #5
Ted and Alice Smith are successful professionals with $250,000 in combined income (all from salary). They have two children (over age 16, so they are not eligible for the child credit) and their itemized deductions are $50,000. They appear to be in the 35% federal income tax bracket. Both their earnings exceed the Social Security tax base, so they pay only the Medicare tax at the margin, which is 1.45% of wages. Their state tax income tax is deductible, so their effective state tax rate would appear to be trimmed from 5% to 3.07%. On additional salary, they might expect to pay 39.52% in tax. (On additional interest income, where there is no Medicare tax, they might expect to pay 38.07% in tax.)

However, the Smiths are in the income ranges in which they begin to lose their personal exemptions (at a rate of about 2.5 cents per added dollar of income per exemption) and itemized deductions (at a rate of about 3 cents per added dollar of income). Four full personal exemptions for 2003 (at $3,050 each) would be $12,200 if not for the restriction, but they only get to claim $8,222.80. Their itemized deductions are reduced from $50,000 to $46,685. Their total tax is $76,726.77. It would have been $2,552.27 less, or $74,174.50, without the phase-outs of the exemptions and the deductions. (We assume the state taxable income is not affected by the federal phase-outs.)

If the Smiths earn an additional $1,000, their personal exemptions will be cut another $97.60 to $8,125.20 and their itemized deductions will be cut another $30 to $46,655. Their taxable income will rise by $1,127.60, not $1,000. Their federal income tax will rise by $394.66, not $350.00. Their effective marginal federal income tax rate is 39.466% instead of 35%. Their total effective marginal tax rate (including Medicare and state taxes) is 45.916%, and their total tax hike would be $459.16. (If they bought a bond earning $1,000 in interest, their added tax would be $444.66, a marginal tax rate of 44.466%.)

Effective Marginal Tax Rate: 45.916%

Old after-tax income
$173,273.23
Added wage income
$1,000.00
Loss of deductions
+$127.60
Added taxable income
=$1,127.60
Added wage income
$1,000.00
Added income tax (@ 35% on $1,127.60)
-$394.66
Added medicare tax (@ 1.45% of $1,000)
-$14.50
Added state tax (@ 5% on $1,000)
-$50.00
Net gain in income (effective marginal rate 45.916%)
=$540.84
New after-tax income
$173,814.07
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