What is marginal tax rate? A guide for employers

Understanding how taxes affect your business is crucial for managing payroll efficiently and ensuring compliance. And one particularly important concept is the marginal tax rate, which helps determine how much your employees owe based on their income.

In this guide, we'll break down the marginal tax rate, how it works, and why it’s essential for your payroll calculations. So let’s jump straight in.

What is marginal tax rate?

A marginal tax rate refers to the percentage of tax applied to your employees' income at each tax bracket. As their income increases, the amount of tax taken on their additional income goes up as well.

For example, if an employee's annual income increases from $50,000 to $60,000, only the income within the new bracket is taxed at a higher rate. This doesn’t mean all income is taxed at that higher rate; just the portion above the bracket threshold.

This directly affects how much your employees take home after taxes and can significantly impact your payroll calculations — especially for higher earners.

It can also affect your employees’ approach to working; if a high percentage of additional earnings will be taxed, it could discourage additional work, investment, or risk-taking. For instance, if someone moves into a higher tax bracket, they may reconsider whether the extra effort or investment is worth it.

How to calculate marginal tax rate

To calculate the marginal tax rate, follow these steps:

1. Identify the tax brackets. As mentioned, tax systems often have multiple income brackets, each taxed at a different rate. In the US, for instance, federal income tax has brackets such as 10%, 12%, 22%, etc.

2. Determine the taxable income. Calculate the individual’s total taxable income after deductions and exemptions.

3. Find the current bracket. Identify the tax bracket that applies to the person’s highest portion of taxable income.

4. Apply the rate for the marginal dollar. The marginal tax rate is the tax rate for the next dollar of income that falls within this highest bracket.

For example, say your country’s tax system has the following brackets:

• 10% on income up to $10,000

• 12% on income from $10,001 to $40,000

• 22% on income from $40,001 to $85,000

If someone has a taxable income of $50,000, they are in the 22% tax bracket. So, if they earn one more dollar, it will be taxed at 22%, meaning their marginal tax rate is 22%.

How does the marginal tax system work in the US?

The US uses a progressive tax system, which means employees are taxed at different rates depending on their income. Currently, the federal tax brackets range from 10% to 37%.

Many US states also apply marginal tax rates, although these vary significantly by state. Some states have flat taxes, while others, like California, have progressive rates similar to federal taxes.

As an employer, it’s important to know that the payroll withholding system already accounts for marginal tax rates. Employees’ paychecks are adjusted accordingly based on their tax bracket, ensuring the correct tax amounts are deducted from each paycheck.

How does marginal tax affect payroll?

Knowing the marginal tax rates helps you to budget payroll more accurately, especially when dealing with salary increases or bonuses for employees in higher tax brackets.

It’s particularly important to pay attention to bonuses, which push employees into higher income brackets and, as a result, are subject to higher marginal tax rates.

As an employer, your contributions to retirement plans, health insurance, or other benefits can also reduce taxable income for your employees, potentially lowering their effective marginal tax rate. You should consider these factors when designing compensation packages.

Common misconceptions about marginal tax rates

There are a few misconceptions around marginal tax rates, as follows:

"All my income is taxed at the highest rate." This is a common misunderstanding. Only the income in the highest tax bracket is taxed at that higher rate — not the entire salary.

Marginal vs. effective tax rate. The effective tax rate is the actual average rate your employees pay on their income after all tax brackets and deductions are accounted for. This is typically lower than the marginal rate for high earners.

Simplifying marginal tax rates

Understanding marginal tax rates is essential for US employers, as it affects payroll, employee compensation, and overall business financial planning.

However, with the right tools, managing this aspect of your payroll can be seamless. Remote Payroll tool not only simplifies and automates your tax calculations, but also ensures compliance across US states (and other countries, if you have employees abroad), making it quick and painless to manage your teams' compensation.

To learn more about how Remote can simplify your payroll and keep you fully compliant, speak to one of our friendly experts today.

Trust G2’s multi-country payroll leader to stay globally compliant

Hire and pay your global team with Remote and get access to our team of global taxation experts.

Get started nowSchedule a demo