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Do you know the difference between a marginal tax rate and effective tax rate?

Years ago I was working at a startup with young people and the subject of taxes came up. Specifically, why taxes mattered and certain things everyone should know.

 

One of the things I highlighted was the difference between your marginal tax rate and the effective tax rate.

 

A marginal tax rate analysis involves understanding the difference between your marginal income tax rate and your effective tax rate.

 

Your marginal income tax rate is important for future tax planning (e.g., calculating taxes on additional income).

 

Your effective tax rate lets you know the average rate at which most of your income is taxed at present. Armed with these two figures, tax planning for this year and next may be easier.

 

What is your marginal income tax rate?

Your marginal income tax rate is the rate at which you would pay tax on your next dollar of taxable income. (It’s also the rate at which your last dollar of taxable income was taxed.) Your marginal tax rate depends on your filing status and on the level of your taxable income.

 

It’s important to remember that the marginal tax rate is not the rate at which all of your dollars are taxed.

 

If you enter a higher tax bracket, only the portion of your income that has crossed the new threshold will be taxed at the higher marginal income tax rate.

 

The rest of your income will be taxed at the lower rates shown in the tax table.

 

Assume Mark is unmarried and has $50,000 in taxable income in 2022. That will put him in the 22 percent marginal income tax bracket (assuming no other variables). That means that the first $10,275 of his taxable income will be taxed at 10 percent, the next $31,500 will be taxed at 12 percent, and only the remaining $8,225 will be taxed at 22 percent.

 

Marginal income tax brackets

Generally speaking, a marginal income tax bracket is the income tax rate at which you’re taxed for a certain range of income.

 

Brackets are expressed by their marginal tax rate. Currently, there are seven marginal tax rates: 10 percent, 12 percent, 22 percent, 24 percent, 32 percent, 35 percent, and 37 percent.

 

The income brackets to which each rate applies depend upon your filing status: married filing separately, married filing jointly or qualifying widow(er), head of household, or unmarried.

 

 

What is the significance of your marginal tax rate?

Your marginal income tax rate is useful for calculating the income tax on additional income, such as the tax on a windfall or a year-end bonus.

 

It’s also important for future tax planning. For instance, if you expect to be in a lower income tax bracket next year than you’re in this year, you might want to defer the recognition of some income until next year.

 

Remember that your marginal income tax rate depends, in part, on your taxable income. Some of your deductions or exclusions may be phased out once you reach certain income thresholds, increasing your taxable income.

 

What is your effective tax rate?

Although your marginal tax rate is a useful figure, your effective tax rate gives you a more complete picture of how much you’ll pay in income taxes over the course of a year.

 

That’s because the effective tax rate takes into consideration any additional taxes you must pay (which increase your tax bite) and any income tax credits you’re entitled to (which lower your overall income tax liability).

 

In contrast, your marginal tax rate only involves the specific income tax on your taxable income.

 

In addition to the tax you must pay on your taxable income, you may have to pay other taxes, such as the alternative minimum tax, self-employment tax, Social Security tax on tip income, or a penalty tax on retirement plan distributions.

 

These items affect your total tax (i.e., the bottom line you owe in income tax), but don’t affect your taxable income — upon which your marginal tax rate is based.

 

 

In addition, there are income tax credits that you may benefit from, such as the child tax credit, the dependent care credit, and various education credits.

 

These income tax credits also affect your total tax, but not your marginal tax rate.

 

That’s where the effective tax rate comes in. Your effective tax rate reveals the average rate of taxation for all of your dollars. It’s calculated as your total tax liability divided by your taxable income.

 

Assume Mark is an unmarried taxpayer whose 2022 taxable income is $50,000. Mark is in the 22 percent marginal income tax bracket. His total tax owed is $6,617 (assuming no other variables). Therefore, Mark’s effective tax rate is approximately 13.2 percent ($6,617 divided by $50,000).

 

Your effective tax rate will usually be lower than your marginal tax rate. That’s because your effective tax rate is the average rate of taxation, and most of your income is generally taxed at rates that are lower than your marginal income tax rate. When your taxable income pushes you into a higher tax bracket, only the portion of your income that has crossed the new threshold will be taxed at the higher marginal income tax rate.

 

Your effective tax rate should generally be used when you’re estimating your total tax liability for the year.

 

For instance, if you’re planning your retirement and want to estimate your tax liability for the year, your effective tax rate will often be more useful than your marginal income tax rate.


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