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Author: TMFSynchronicity Three stars, 500 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 35400  
Subject: Re: compare real tax rate versus marginal rate Date: 12/31/2000 4:38 PM
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But if one already has other income to put one in to a particular marginal tax rate, wouldn't it be better to use the marginal tax rates in the comparisons?

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No. Because while you may be paying 31%, you are actually averaging your tax rate. And it is the overall tax rate that is important, not the marginal rate.


No. It is the marginal rate that is important.

Here's a quick example: Let's say that a person's first 10,000 of income will be taxed at zero percent, thanks to deductions and exmeptions. Then the next 25,000 will be taxed at 15%, and the next 50,000 above that will be taxed at 28%. (And to keep this simple, let's assume no state tax).

Now, let's say our erstwhile investor (we'll call her Alice), earns 50K in salary. She is in the 28% bracket, but her overall tax "rate" is

10,000 * 0 = 0
25,000 * .15 = 3,750
15,000 * .28 = 4,200
0 + 3,750 + 4,200 = 7,950/50,000 = 15.9%

Now, Alice has some additional savings she can invest in a fixed income instrument. She has two such instruments to choose from. One is a taxable investment that earns 6.5%, the other is a tax exempt instrument that earns 5%.

Under your calculation, you would choose the taxable investment. Why? because you would calculate that for every $1000 she invests in the taxable instrument, she would get $65 in interest. You would then apply the average tax rate of 15.9%, and figure that this would leave her, after tax, a total of $65 less (65*.159=10.34) or 65-10.34=54.66

So, you would calculate that for every $1,000 Alice invests in the taxable instrument, she would wind up with 54.66 after tax. The non-taxable instrument only pays 5%, or $50 interest for every $1,000 invested.

Unfortunately, that is incorrect. Alice currently earns 50K. Unless she gives up her job or takes a pay cut, she gets that 50K regardless of whether she invests in a taxable or tax-free instrument.

Right now, if she invests an extra 1,000 in a taxable instrument, she will earn $65 before tax, BUT that $65 will be taxed at her 28% marginal rate. $65*.28=18.2, 65-18.2=46.80. So, for every $1,000 she invests in the taxable instrument, she will only have an extra 46.80 in her pocket after taxes.

By contrast, that tax-free instrument would give her $50 after taxes. In this simplified example, the tax-free instrument is the better choice.

In the end all that counts is how much is left in your pocket when all is said and done.

Exactly. And that is why you will usually have to use your marginal tax rate when calculating which instrument is better.

hope this is useful,

-synchronicity
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