When I was in university I couldn’t have cared less about knowing the difference between average tax rates and marginal tax rates. I just knew that I got a nice juicy refund every spring (when it was sorely needed) because as a student I got a lot of cool tax breaks and I didn’t make much money. In saying that is all that I knew, I should mention that, that was more than almost all of my friends knew!
No System Is Perfect
The fact that there is a difference between your average and marginal tax rates is due to our progressive taxation system. The main idea behind our current system (supposedly) is that the more money you make over a certain point, the more of it you can afford to give to the government and contribute to the greater social good in the form of increased tax rates. In practice of course, all it does is make accountants rich (paid to find loopholes) and squeeze middle-class income earners – but I digress. If you take a quick look at a Canadian tax table, you will quickly see that everyone gets to earn their first 10K or so without any taxes owing on it. From there, at each new tier, a little more of your money is taken. The tax rate you pay on the “last dollar of income you make” or your last tier that you fit into is your marginal tax rate. The average tax rate is pretty self-explanatory. It is the tax rate you are paying if you’re averaged out all the tiers you are in.
So Now You Know What The Tax Rates Are, Now What?
The real reason for knowing the difference between the two (other than having the security of knowing a little about your personal financial situation) is to figure out the implications for your savings, and to minimize how much you hand over to Uncle Sam (I don’t know what the equivalent is in Canada). One example of this is the decision to put your savings in an RRSP vs a TFSA. If your marginal tax rate for the year will be higher than what you are likely to pay in retirement, then an RRSP might make more sense for you. It also useful in considering what investments to make. Take a look at presidential candidate Mitt Romney as a prime example of this. The guy pays an astounding average tax rate of 13.9%! How does a millionaire get away with paying so much less in taxes than a working-class individual? It’s simple, he plans his income from sources that have low average tax rates such as investment dividends. If you’re to make the most out of your earnings and your savings sacrifices, it is important to understand how much you are helping yourself by looking at your marginal tax rate.
Start Saving More
Knowing your marginal tax rate also helps you understand the value of a pre-tax dollar vs a post-tax dollar. There is an old saying that says $1.00 saved is a $1.40 earned. This is very true if your marginal tax rate is 40%. Think about the fact that you would have to earn that much more to give yourself $1.00 of net income, whereas every dollar you don’t spend (save) is obviously equivalent to $1.00 of net income. It’s kind of an interesting realization.
It’s also nice not to be intimidated when you talk to someone about doing your taxes, or tackling them yourself. I know this much, don’t go to HR Block!