Marginal income and marginal income tax sound similar, but they refer to vastly different concepts. If you run a business, you should understand the basic differences between these two terms. Manufacturing and production businesses, in particular, need to understand what marginal income means.
Marginal income refers to the difference between sales revenue and variable costs. For example, if your company sells $100,000 worth of products and has $40,000 in variable costs, it has $60,000 in marginal income. Variable costs represent production costs that change. This can include manufacturing supplies and energy costs that differ from month to month but not fixed costs, such as rent, business insurance, and administrative payroll, that typically stay the same.
Businesses have the option of tracking their total marginal income, or they can break down these amounts to focus on the marginal income associated with specific products. This individual focus often proves a useful way to track and compare the profitability of different items your company makes or sells.
Marginal Income Tax
In contrast, marginal income tax basically refers to tax brackets. To clarify, the Canada Revenue Agency (CRA) applies income tax at different rates depending on the amount of income.
For the 2018 tax year, tax margins are:
- $46,605 or less pay 15%
- $46,605 to $93,208 pay 20.5%
- $93,208 to $144,489 pay 26%
- $144,489 to $205,842 pay 29%
- More than $205,842 pay 33%
For example, imagine you earn $50,000 in 2018. Using the rates in the bulleted list, your taxes amount to:
- 15% or $6,990.75 for the lowest tier, plus
- 20.5% or $695.98 on the amount between $46,605 to 93,208
In total, you would pay $7,686.98 on taxable income. You pay a higher tax rate, 20.5%, just on the second $45,916 you make, but you only pay 15% on the first $45,916. You gradually pay more as your income goes up.
The rate continues to increase progressively with higher amounts of income. Marginal income tax doesn’t refer to the final or effective tax rate of individuals or businesses. It only refers to the rate assessed on income in each bracket.
Why Knowing Your Marginal Tax Rate Matters
Knowing your marginal tax rate can help with business planning and tax savings at the end of the year.
For instance, imagine you run a graphic design business as a self-employed person, and a client hires you for a project on Dec. 15. The job nets you $5,000 in income, and you have $90,000 in income already before you landed this job. You choose to take an up-front deposit of $1,000 at the start the project before receiving the $4,000 a month later on Jan. 15. The income you receive gives you $91,000 in income for the tax year, which is below the third tier of the marginal tax rates.
Here’s the difference. Rather than pay 26% on $3,169, or $823.94, of income above the $93,208 threshold from the previous tax year, you would pay just 15% or $475.35 on the revenue for the next tax year. That’s a difference of $348.59 that you don’t pay on your previous year’s tax bill. Rather than owe that money to the CRA, you can invest the dollars into new computer software, expand your marketing tools or save it as a profit.
What is an Effective Tax Rate?
Your total tax liability as a percentage of your income is your effective tax rate. Determining your total tax liability involves calculating tax owed at each margin up to your total income.
Simply take the sums of each tier of marginal tax rates and divide by your total income to arrive at your effective overall tax rate for your income. For the above example, your effective tax rate on $100,000 earned in 2018 is around 18%. That percentage is in between the first and second tiers of the marginal tax rate structure.
By knowing how tax rates affect your business, you can better plan for the future and keep more cash in your account when you owe taxes. QuickBooks’ income tracking software helps you accomplish this kind of planning when it comes to tax time. This kind of software makes record keeping for tax purposes more efficient.
Running a small business requires you to navigate all kinds of financial concepts. When you understand the differences between marginal income and marginal income tax rates, you can better communicate with accountants, lenders, and financial professionals concerning your business’s needs.
QuickBooks Online offers a variety of tutorials that help you learn as you record and track your company’s revenue and expenses, and it can also help you maximize your tax deductions. Keep more of what you earn today.