Marginal vs Effective Tax Rate - Understanding the Difference
How the US tax system works
Before diving into a discussion of marginal and effective tax rates, it’s important to understand how our tax system works. In the United States, we have a system of progressive taxation where the dollars that you earn fall into different tax brackets. A common misconception is that all of the income you earn is taxed in the one tax bracket that you fall into. This is incorrect, a better way to visualize it is that each tax bracket is a “bucket” that you fill up with taxable income, and all of the income in each bucket is taxed at different rates. Let’s look at an example of a single earner who made $80,000 in 2022. This person would pay 10% on the first $10,275 they earned, 12% on the amount between $10,276 to $41,775, and 22% on the amount between $41,775 and $80,000.
What is marginal tax rate?
The marginal tax rate is the tax paid on your last dollar of income. In the example above, we would say that the person is in the 22% marginal tax rate, as the highest tax bracket that part of their income is taxed at is the 22% bracket. The marginal tax bracket is important to understand because it informs the decisions that we make to save money on taxes. Any tax-saving measures taken have an impact on your tax bill based on your marginal tax rate. In our example, every $100 that we can reduce that person’s taxable income by would reduce their tax bill by $22 since their marginal tax rate is 22%.
How do you calculate your marginal tax rate?
The current tax brackets can be viewed on the website linked below. To figure out your marginal tax rate, simply find your taxable income and filing status and then view the corresponding federal income tax rate. In the above-mentioned example for a single person making $80,000 per year, the marginal tax rate would be 22%.
What is effective tax rate?
The effective tax rate is the total percentage of your income that is spent on taxes and is always lower than your marginal tax rate because of our progressive tax system. The effective tax rate is not quite as important to understand as the marginal tax rate for planning purposes, however, it is always good to have an understanding of the total percentage of your income that you are paying in taxes.
How do you calculate your effective tax rate?
Your effective tax rate can be calculated by taking the total amount you pay in taxes and dividing it by your taxable income. Sticking with the same example above with a single person making $80,000, their total federal income tax would be $13,217. ($10,275 X 10% + $31,500 X 12% + $38,225 X 22%). If we take this $13,217 divided by their taxable income of $80,000, we get an effective tax rate of 16.5%, substantially less than their marginal rate of 22%.
This article was written and reviewed by Chad Gaines, CPA
