Tax question...

[IdealFugacity]

The first dollar we make and the last dollar we make are taxed at different (and increasing) rates, as long as we are lucky enough to make more than $7,825 a year.

When analyzing money market funds, bond funds, and other funds which are either tax-exempt or -managed, why do we use a simple calculation that uses our "Tax bracket", instead of our "averaged tax bracket"?

It seems pretty significant that if you're making say $60,000 a year, your tax rate will actually be: 17.7% by my calculations, using http://www.moneychimp.com/features/tax_brackets.htm, arriving at about $10,600 in taxes.

Am I doing this the wrong way?

[Big TR]

The reason you use the bracket percentage is because this incremental income will be taxed at that rate.

Easy to see example:
Tax Bracket 1 = 0% up to $100
Tax Bracket 2 = 90% on every dollar over $100.

Presently you make $100, so you pay no tax. Now you invest in the money market fund and make $5. You are taxed at 90% on this $5, so you pay $4.50 in taxes. Your effective tax rate is $4.5/$105 = 4.2%.

Next year you make $400. Your tax liability is $270/$400 = 67.5%. You can see the effect of the bracket even further now. On every additional dollar you earn, you are only going to bring home 10% of that money.

Make sense?

[Platonic]

[ QUOTE ]
The reason you use the bracket percentage is because this incremental income will be taxed at that rate.

Easy to see example:
Tax Bracket 1 = 0% up to $100
Tax Bracket 2 = 90% on every dollar over $100.

Presently you make $100, so you pay no tax. Now you invest in the money market fund and make $5. You are taxed at 90% on this $5, so you pay $4.50 in taxes. Your effective tax rate is $4.5/$105 = 4.2%.

Next year you make $400. Your tax liability is $270/$400 = 67.5%. You can see the effect of the bracket even further now. On every additional dollar you earn, you are only going to bring home 10% of that money.

Make sense?

[/ QUOTE ]

I don't think you said anything different than what he is talking about..

[Big TR]

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I don't think you said anything different than what he is talking about..

[/ QUOTE ]

[ QUOTE ]
When analyzing money market funds, bond funds, and other funds which are either tax-exempt or -managed, why do we use a simple calculation that uses our "Tax bracket", instead of our "averaged tax bracket"?

[/ QUOTE ]

His question was why use tax bracket instead of averaged tax bracket. My example showed him why it is imperative to use your incremental tax bracket instead of your average tax bracket.

[BradleyT]

Using your $60,000 -
Investment A returns $4,250
Investment B returns $4,300

Investment A is taxed at 25% = $1062.5 = $3187.50 return
Investment B is taxed at same rate + 28% = $1076.50 = $3223.50 return

I'm not sure there are any scenarious where you would decline an investment because it would put you in a higher tax bracket - you're "take home pay" is still higher.

[RicoTubbs]

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I'm not sure there are any scenarious where you would decline an investment because it would put you in a higher tax bracket - you're "take home pay" is still higher.

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That's not the question. The question is, when you're deciding between a tax-exempt investment and a taxable investment, which tax rate do you use in your decision-making analysis? The answer is the marginal tax rate.

In fact, the answer to virtually anything related to economics is "the marginal one".

[ahnuld]

rico is right

[thing85]

Exactly right. Everything else equal, you don't give a [censored] about your average tax rate (well, you do, but it's irrelevant here). You want to know at what rate each additional dollar will be taxed - the marginal rate.

Before deciding to invest or not, let's say you have your established taxable income, $X, during a given year. This is the fixed salary or whatever that you know you will earn regardless of other investments. Your expected tax liability = your effective (average) tax rate * $X. Yes, this should be obvious. Now, when considering an investment and its return, $Y, you're looking at ADDING that to your current taxable income. Do you see why the marginal tax rate is the relevant one?

Of course you could play games with the numbers and say that the timing of the investment return and your salary occur simultaneously, thus making it difficult to assign a specific tax bracket to a piece of your income - in this case, you just aggregate the income and apply your effective tax rate. Looking at it this way is merely changing the syntax of your income composition and really isn't the usual or practical way of looking at it.