It’s no secret that the IRS tax code is complex. Understanding marginal vs. effective tax rates can help you be more informed and confident during tax time. Marginal tax rate refers to the percentage of tax applied to the last dollar of income earned, while effective tax rate is the average rate at which overall income is taxed. Recognizing the difference between marginal tax rate and effective tax rate can help you to better understand your tax return and tax liability.
Key differences between marginal tax rate and effective tax rate
Understanding the difference between marginal tax rate and effective tax rate is essential for grasping how taxation impacts your income and finances. The United States uses a progressive tax system, meaning higher tax rates apply as your income level increases. These income levels are also referred to as tax brackets. The marginal tax rate is the percentage you pay on your last dollar of income, reflecting the tax rate of your highest tax bracket. The effective tax rate is the average rate you pay on all your taxable income. Here are a few of the key differences between the two:
- How rates are calculated — Your marginal tax rate is determined by the highest tax bracket your income falls into. Your effective tax rate divides your total tax liability by your annual income, so it shows what the overall percent of your earnings go toward taxes.
- How rates impact tax planning —The marginal tax rate is important for making decisions about additional income, such as accepting a raise or taking on extra work, as it affects how much of that income you will take home. On the other hand, the effective tax rate is better for understanding overall tax liability and for budgeting purposes.
- How you perceive tax liability — You might feel your tax burden is higher or lower depending on the rate you focus on. The marginal tax rate can sometimes feel steep because it is based on the highest part of your income, but your effective tax rate reflects what percentage you pay relative to your total income, so it’s typically lower.
What is a marginal tax rate?
In the United States, our government exercises a progressive tax system, which means the higher your income, the higher your tax rate will be. A marginal tax rate is the amount of tax that applies to each additional level of income.
Taxpayers are divided into seven brackets: 10%, 12%, 22%, 24%, 32%, 35% and 37%. These percentages are your marginal tax rates.
How do you calculate your marginal tax rate?
The most common misconception with marginal tax rates is that X% of your entire income is owed to the government, depending on which tax bracket you’re in. But that’s not how tax brackets work:
For example, let’s say you’re a single filer and your annual income is $32,000. You decide to take the standard deduction ($12,000), which would lower your taxable income to $20,000. This would put you into the 12% tax bracket.
Instead of handing over 12% of your $20,000 taxable income to Uncle Sam, you actually only pay 12% of the money over $11,600.
Here’s why: In the first bracket, you would pay 10% on income from $0 to $11,600.
10% of $11,600 = $1,160
Any income over $11,600 moves to the next bracket. Income between $11,601 to $47,150 is taxed at 12%.
In this example, you would only have to pay 12% of $8,400 because that’s the amount of money you have left in your taxable income of $20,000.
12% of $8,400 = $1,008
Your marginal tax rate is the last bracket that your income falls into. In this example, your marginal tax rate is 12%.
If you have a higher income such as $100,000, you will repeat the same process for each bracket until you reach your marginal tax rate. Someone with a taxable income of $100,000 would have a marginal tax rate of 22% because this is the rate for income between $47,151 to $100,525.
What is an effective tax rate?
An effective tax rate is the actual percentage of your annual income that you owe to the IRS, after accounting for various deductions, credits, and other adjustments. Unlike the marginal tax rate, which applies to the last dollar earned and increases as your income rises, the effective tax rate reflects the total taxes you pay as a percentage of your total income.
How do you calculate your effective tax rate?
To calculate your effective tax rate, divide your total tax liability by your annual income.
total tax liability / annual income
= effective tax rate
Let’s use the earlier example to better understand this calculation. When you add up the amounts from the example above, your total tax liability would equal $2,168. Divide that number by your income before taxes ($32,000) and you’ll get an effective tax rate of 6.8%.
$2,168 (total tax liability) /$32,000 (annual income)
= 6.8% (effective tax rate)
Now, you’ll also need to factor FICA taxes – Medicare and Social Security – into the equation, as well as any state and local taxes.
How do marginal and effective tax rates impact your return?
Understanding how these rates interact can help you make informed decisions that may reduce your tax liability or increase your refund, enabling better financial planning and decision-making for the future.
Whenever you prepare your taxes, keep in mind that the marginal tax rate is the highest tax rate that applies to a portion of your income, while the effective tax rate is the actual percentage you pay. When you file with TaxSlayer, we do all the math for you to make your filing experience as easy as possible
