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Income Taxes Are Marginally Effective: Marginal Rates, Effective Rates and the Power of Long-Term Capital Gains

In a perfect world, the start of April would only signify the beginning of both warmer weather and the professional baseball season. Sadly, along with Opening Day, the onset of April brings with it everyone’s favorite national un-holiday: Tax Day.

In advance of this year’s tax filing deadline of April 18th, we wanted to share a little bit of information that might shed some light on your 2015 Federal tax liability.

The key concept of the Federal tax system is that it is progressive in nature. This means that different “buckets” of amounts of income are taxed at different rates, with progressively higher amounts of income being taxed at progressively higher rates. The rate that matches the last dollar of income you receive is referred to as your marginal rate. These rates are the same if you are single or married, though the actual numbers that define the ranges of the buckets are different. Here is what the rates look like for 2016:

Tax RateSingleMarried Filing Jointly
Taxable income over……but not overTaxable income over……but not over


Embedded in this chart are three important but often misunderstood income tax concepts.

“Taxable Income” Doesn’t Cover Everything

“Taxable income” is often much less income than you’ve actually received. At the very bottom of the first page of your tax return, you’ll see a row titled Adjusted Gross Income (AGI). For most people, this amount captures pretty much every dollar that comes in the door, including wages, taxable interest, capital gains, Social Security, IRA distributions, etc. But taxable income is the amount that’s left after you subtract any personal exemptions and itemized/standard deduction amounts from AGI. By definition, taxable income is going to be less than AGI.

Your Marginal Rate Isn’t a “Flat Tax”

One of the most common misconceptions about income taxes is that a taxpayer arrives at his/her tax obligation by simply multiplying the amount of taxable income by the corresponding marginal rate. That would effectively be a “flat tax” system instead of a progressive system.

Instead, your tax bill is derived by figuring out the amount of tax you owe at each bracket, and then adding the whole thing up. Consider the following example:

A single taxpayer has an adjusted gross income (AGI) of $60,000 and a taxable income (after exemptions and deductions) of $50,000. Using the 2016 table gives us the following:

Taxable IncomeMarginal RateIncome Tax
$1 - $9,72510%$973
$9,726 - $37,65015%$4,189
$37,651 - $50,000 (last dollar)25%$3,087
Total Tax Bill$8,249

Even though this person’s last dollar was taxed at a rate of 25%, when you divide the total tax bill of $8,249 by the Adjusted Gross Income of $59,750, you come up with an average or effective tax rate of 13.7%.

Your Marginal Rate Doesn’t Apply to Everything[i]

The IRS breaks down income into two types: ordinary income and long-term capital gains/qualified dividends. Marginal rates apply to ordinary income, which includes wages, Social Security, IRA distributions, and just about anything that isn’t capital gains or qualified dividends.

Long-term capital gains are gains realized upon the sale of an asset that’s been held for longer than a year. Without getting too technical, “qualified dividends” are dividends paid on assets that have been held for a sufficient length of time, as defined by the IRS.

Both long-term capital gains and qualified dividends are taxed at lower rates than ordinary income. For most people, that lower rate is 15%. If your taxable income lands you in the 10% or 15% tax bracket, however, any amount of your taxable income that consists of long-term capital gains or qualified dividends is taxed at a rate of 0%! That’s free money![ii]

Let’s change up our earlier example:

A single taxpayer has an adjusted gross income (AGI) of $60,000 and a taxable income (after exemptions and deductions) of $50,000. This time, $10,000 of that $50,000 of taxable income is made up of qualified dividends and long-term capital gains.

Using the 2016 table gives us the following:

Taxable IncomeMarginal RateIncome Tax
$1 - $9,72510%$973
$9,726 - $37,65015%$4,189
$37,651 - $40,000 (last dollar of ordinary income)25%$587
$10,000 of capital gains15%$1,500
Total Tax Bill$7,249

Now that a portion of this individual’s income is taxed at the lower rate of 15%, the effective rate drops to 12.1% instead of 13.7%.

Taxes can be tricky. But our knowledge of the brackets, rules and rates helps clients of Woodward Financial Advisors keep their taxes as low as they can be. If you think we might be able to help you understand your tax situation, let us know.

[i] This simplified summary doesn’t get into the 3.8% tax on Net Investment Income for folks making more than $200,000 (single)/$250,000 (married), or the different tax rates applied to realized gains upon the sale of real estate or collectibles.

[ii] If your taxable income lands you in the 39.6% bracket, you pay a rate of 20% on any long-term gains or qualified dividends.