Marginal Tax Rate

Your marginal tax rate is the highest rate that you are taxed. For many people, a portion of their income is taxed at one rate, and the rest is taxed at another rate. For instance, if you make right around $40,000 a year, you may pay 15% on the first $20,000 or so and 28% on anything over $20,000. So, let’s break that down:

15% of $20,000 is $3,000
28% of $20,000 is $5,600
Total tax liability is $8,600

In this case, your marginal tax rate would be 28%, the highest rate at which your income is taxed.

Average Tax Rate

The average tax rate is the actual percentage of income going to pay taxes. In the example above we can calculate average tax rate as follows:

$8,600 / $40,000 = .215 * 100 = 21.5%

So, in this example, your average tax rate is 21.5%, a bit lower than your 28% marginal rate. It’s good to know this because this represents your actual tax liability.

Why the Two Tax Rates?

In the United States, we have something called a progressive tax system, meaning, the more money you make, the higher your tax rate. If the person in the example above only made $20,000, he’d wouldn’t have had to pay the 28%…instead only the 15% would apply. Our progressive tax system taxes you at a lower rate for the first so many dollars you make, everything over that amount gets taxed at a higher rate, and so on until you reach the cap, which, for 2008, was 35%.

So, it all boils down to this, your marginal tax rate is the highest rate at which you’re taxed, but it does not represent the percentage of your income that goes toward paying taxes. That number is the average tax rate.

Incidentally, here are the 2008 tax rates for Individuals, from Edwards Jones Investments:

The home ownership tax deduction is the biggest and one of the few remaining tax deductions for the middle class American, so it’s not something that’s easy to let go of, but there’s an incredibly simple answer to that question.

If I told you that if you give me a dollar, I’ll give you 33 cents back, would you go for that? If so, give me a call, I’m sure we can work something out . All kidding aside, that’s what the home-ownership tax deduction amounts to.

Let’s say you have $85,000 a year in taxable income; if you’re single that puts you in the 28% tax bracket (see chart).

Let’s also say the interest payments on your home are $2,500 a month, $30,000 a year. Since your mortgage interest is tax deductible, you can write off all $30,000, which will give you an $8,400 tax refund.

Now, what if you pay off your home? You don’t get the $8,400 tax deduction, but you also don’t pay the $30,000 in interest in the first place. So, why pay $30,000 to get an $8,400 refund in April?

There Are Benefits to Not Paying Off Your Home

Don’t get me wrong, I’m not always in favor of paying off your home, in most cases it needs to be a personal choice you make after you’ve looked at all the options. The tax break can be used to your advantage with arbitrage, which basically means you’re borrowing money to invest and earning more on the investment than you’re paying on the loan. For example, if you pay $30,000 a year in interest, that’s equivalent to 6% on a $500,000 loan. If you receive an $8,400 tax refund, your effective interest rate on that loan is only 4.3%, not 6%; so if you can find an investment that pays more than 4.3%, you’ll be better off not paying off your home.