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Marginal tax rate

Marginal tax rate is the tax rate paid on the last dollar of income.

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Expanded Definition

In the income tax system used by the Federal government and many state and local governments, tax rates are progressive. To minimize taxes on the poorest workers, rates are low in the lowest brackets but increase at higher income levels.

When considering a new investment opportunity that will generate an additional dollar of income, it is presumed that all of your deductions and lower tax rates have been used by your existing income. Hence, the next dollar of income will be taxed at the highest tax rate, which is often called your marginal tax rate.

Marginal tax rates are most important in considering investment municipal bonds or tax free bond funds. A high marginal tax rates makes these investments more attractive than their taxable equivalents.

The marginal tax rate is readily used to calculate taxable equivalents. For example, a 30% marginal tax rate implies that $1 of taxable income will net $0.70 of after-tax income. Similarly a tax-free bond or bond fund paying 5% is equivalent to 5 divided by 0.70 or 7.14% taxable yield. For double tax free investments, the sum of state and federal tax marginal rates is used. A triple tax free investment would use the sum of state, federal, and local marginal rates.

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