Income tax
Marginal tax rate
Your marginal tax rate is the rate of tax you pay on the next dollar of taxable income you earn, which depends on the bracket your income falls into.
The marginal tax rate is the percentage of tax that applies to an extra dollar of income. Under a progressive system, different slices of your income are taxed at different rates, and your marginal rate is the rate on the top slice. It is not the same as your average rate, which is your total tax divided by your total taxable income and is always lower.
Knowing your marginal rate is useful when making decisions about deductions and extra income. A deduction reduces your taxable income from the top slice, so it is worth roughly the marginal rate. If your marginal rate is 30%, a $1,000 deduction saves about $300 in income tax. If extra income of $1,000 falls in the same bracket, about $300 of it goes in tax.
The Medicare levy adds to the effective marginal rate for most residents. At most income levels, the levy is generally 2% of taxable income, and this is on top of the income tax rate. For some people, losing entitlements or offsets as income grows can make the effective marginal rate higher than the headline rate. This is especially noticeable for those relying on income-tested payments.
A common misunderstanding is that earning more and crossing into the next bracket means you take home less. That is not correct. Only the portion above the threshold is taxed at the higher rate, so extra income still leaves you better off after tax, even if the percentage you keep is lower than before.
For business owners, the marginal rate that matters depends on the structure. A sole trader is taxed at personal marginal rates on business profit. A company pays the company tax rate, which is 25% for a base rate entity and 30% for other companies. Because company and personal rates differ, the same dollar of profit may be taxed differently depending on who earns it.
The brackets and rates change over time, so check the ATO website for the current figures. GST does not alter your marginal income tax rate, although how you treat GST in your income and deductions affects the numbers you start with. This is general information only, so confirm your position with the ATO or a registered tax professional.
Worked example
Suppose a sole trader's next dollar of taxable income is taxed at a marginal rate of 30%, plus 2% Medicare levy, an effective 32%. If she buys a deductible $2,000 item for the business, her taxable income falls by $2,000 and her tax falls by about $2,000 x 32% = $640. The net after-tax cost is about $1,360.
Practical tips
- Use your marginal rate, not your average rate, to estimate the value of an extra deduction or extra income.
- Include the Medicare levy when working out the effective rate on extra income.
- Check the ATO website for current brackets, since rates and thresholds change over time.