How Do Marginal Tax Rates Work?

Written by Chris DeVito

As I've gotten older, I've noticed how certain memories really stick with you. Whether memories from experiences or remembering something someone said. One such memory that pops into my mind, and quite frankly changed the way I thought about money and finances came in college. I was working as a waiter at an extremely high-end steakhouse, the ole' Outback Steakhouse, when the owner said something that I found extremely off. I don't remember the exact words, but it was something along the lines of him insinuating that if he made more money than the IRS would tax him at a higher rate and that because of this he would wind up with less money in his pocket than if he just made less money to begin with. Did you follow that? Doesn't seem to make sense, does it? Well... that's because it doesn't. I know Jay-Z said mo' money mo' problems, but this just didn't make sense to me.

What this owner failed to understand was our Marginal Tax-Bracket. As income increases, your tax-bracket goes up, it does NOT however, affect your lower brackets of income. For example, let’s look at the current Federal Tax-Brackets below.

Note: for this example, we will simply use the 2024 “Single” Rate Tax-Bracket.

So, let’s say the owner of this restaurant one year made $240,000, which would put him in the 32% bracket. From his understanding, if he made just another $4,000 that year, he would be bumped up to 35% and be left with less money than if only made the lesser amount. This is simply not the case; he would only be paying 35% of the amount that fell into that bracket. Seems simple, but many people do not realize this.

Where this does come up a lot, however, is when people select which type of 401(k) to contribute to. The idea of “being in a lower bracket” comes directly from the fact that we have a marginal tax system. For someone making over $600,000 per year, the idea of deducting $23,000 to go into their 401(k) may be an attractive concept. They’re making a bet that when they eventually use that money that it will be taxed at less than the roughly 37% it would have otherwise.

All this is to say that no, making more money doesn’t cause your overall tax rate to go up on all your income. Do you keep less of the 600,001st dollar that you make vs the 1st dollar? Yes. Should you stop trying to make more money because it’ll be tax higher than the rest of your income, that, well that’s up to you.

Resources: https://www.nerdwallet.com/article/taxes/federal-income-tax-brackets#2024-tax-brackets-and-income-tax-rates

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