Marginal Tax Rates Explained—In a Way That Actually Makes Sense

Do you know what a marginal tax rate is? It’s crucial you do. Watch this short video and you’ll wonder why no one ever explained it this clearly before.

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Please watch and share this video. It’s short. It’s basic. But it’s important. I’m going to discuss the definition that people must understand because it comes up a lot in financial planning and investment decisions. It’s one that many of you will argue, “Dave, everyone knows that!” No they don’t. Trust me.

Marginal tax rate. Hear that expression all the time, but what exactly does it mean? The marginal tax rate is the amount of additional tax paid on the next dollar you earn. Expressed as a percentage. Or, another way to look at it is, it’s the amount of tax you would save by reducing your taxable income from its current level by a dollar.

If you’re in a 30% marginal tax bracket and you earned an extra $100, you would lose $30 to the CRA. Or, if you put $100 in your RRSP and therefore reduced your taxable income by that amount, you would save $30 in tax. Now, this is not to be confused with your average tax rate.

Very different. Your average tax rate is simply your total tax paid, divided by your income. Basic stuff for many of you, but confusing for some. So let’s go through a quick example. It’ll help cement this. A fictitious country’s tax rates are: 0% on the first $20,000 of income, 25% of the next $80,000 and 50% on any income above $100,000. Person A is earning $10,000 a year.

0% average tax rate is 0% marginal tax rate, as they’re still below the $20,000 income bracket. Easy peasy. Person B is earning $140,000 a year. Hmm, how much tax would they pay? Well, zero on the first $20,000. $20,000 on the next $80,000, because that’s all in a 25% bracket. And $20,000 on the last $40,000 because anything above 100 is taxed at 50%.

So the total tax is $40,000, therefore the average tax is 28.57% — $40,000 divided by 140. The marginal tax bracket is though, 50%. That’s the level at which the next dollar would be taxed. Again, I know this is straightforward, but it fools a lot of people. I mean, how often do you hear someone complain, “I pay 54% of everything I make in income taxes!”

No, you don’t. That’s not to say that person doesn’t pay a lot in taxes, but what they’re saying is still wrong. That’s their marginal rate, not their average rate. Understanding what a marginal-tax rate is, is so important as it comes into play often with strategic decisions and tax planning. Boring, but shouldn’t be ignored. Like me. 📍