Effective vs. Marginal Tax Rate

Sitting down to file taxes can sometimes bring an unpleasant surprise of taxes owed or a pleasant relief of a hefty refund. After filing taxes for years, you might wonder how the government calculates your taxes. Understanding effective and marginal tax rates can clarify how you end up paying a specific amount in taxes and how to lower your overall taxable income. An effective tax rate is an average rate you pay in taxes, while the marginal tax rate is the rate paid on the last dollar of income. For proper tax planning, you may want to consider working with a financial advisor.

What Is an Effective Tax Rate?

Your effective tax rate is the percentage of income paid in taxes. In other words, you can calculate your effective tax rate by dividing your taxes paid by your taxable income. Effective tax rate accounts for federal income taxes and excludes the following:

• FICA taxes
• State taxes
• Local taxes
• Self-employment tax

Say a single filer made $60,000 last year. They paid $8,000 in tax and took the standard tax deduction of $12,950, reducing their taxable income to $47,050 ($60,000 – $12,950). As a result, their effective tax rate is $8,000 divided by $47,050, which is 17%.

What Is a Marginal Tax Rate?

The marginal tax rate is the progressive tax system the federal government applies to your income. For instance, while the first $10,275 of your income has a 10% tax rate if you’re a single filer, any dollars made after that amount are taxed at a higher rate.

Your marginal tax rate jumps to higher percentages at specific thresholds of income. See the table below for the breakdown of how marginal tax rates apply to tax brackets:

Roth IRA Deductions – 2022

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Traditional IRA Deductions – 2022

Example of a Marginal Tax Rate

Say a married couple filing jointly made $100,000 last year. They take the standard deduction of $12,950, making their taxable income $87,050. Using the chart above, their income has three marginal tax rates. Specifically, the first $20,550 has a 10% tax rate. Then, the income from $20,551 to $83,550 receives a 12% tax rate. Finally, their income from $83,551 to $87,050 has a 22% tax rate.

Combining the figures from these rates can help calculate the total taxes paid:

• The first segment of taxes means $20,550×0.10=$2,055.
• The second segment means $20,551 through $83,550, a total of $62,999x.012=$7,559.88.
• The third segment means $83,551 through $87,050, a total of $3,499.

Therefore, the total taxes paid are $13,113.88.

The Difference Between Marginal and Effective Tax Rates

The difference between marginal and effective tax rates is breaking your income into separately taxable chunks (for marginal) and calculating the average tax rate using all your taxes versus all your income (for effective).

In other words, you can zoom in on a specific portion of your income and see how it has a different tax rate than other parts according to the United States’ progressive tax system. Or, you can take your total taxes paid and compare them to your total taxable income to understand your effective tax rate.

How Federal Tax Brackets Work

Federal tax brackets apply higher tax rates for higher income levels. Each time you jump to the next tax bracket, you pay more taxes on the next portion of your income. However, instead of taking your gross annual income, the government allows taxpayers to apply tax deductions and credits to their income before paying taxes. As a result, you can lower your taxable income to an extent before fitting your income into the matching brackets.

That said, the phrase “your tax bracket” is a misnomer, as your income likely falls into multiple tax brackets. However, this phrase often designates your highest tax bracket – which also produces confusion. For example, if your income was $150,000 last year, the highest part of your income ($89,076 to $150,000, specifically) is in the 24% tax bracket. But, all income leading up to $89,076 has lower tax rates, as seen in the table above.

To determine your tax bracket, combine your income from your W2 and 1099 documents. Then, subtract the deduction you plan to take (itemized or standard) from this number. This calculation will give you a dollar figure you can match with the tax bracket table. Remember, your income will likely fall into multiple brackets, with the first $10,275 taxed at 10% for single filers and so on.

The Bottom Line

Effective and marginal tax rates are two ways to look at your taxes. While calculating one instead of the other doesn’t change how much taxes you pay, comparing the two can help you understand why you’re paying the taxes you owe and how to lower your tax liability. In addition, your top tax bracket designates the taxes you pay on your highest level of income, but it doesn’t reflect how much taxes you pay on your entire income.

Tips for Using Marginal and Effective Tax Rates

• Now that you know how to calculate marginal and effective tax rates, you’re probably wondering how to reduce your taxable income. A financial advisor who specializes in taxes can help. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
• Taking the standard tax deduction makes sense for many filers. However, it can hurt to see items you can’t deduct, like mortgage interest and medical expenses. Fortunately, you can make up ground using certain tax breaks without itemizing.
• Inflation has affected every facet of life this year, from fuel and food costs to government expenses. As a result, your taxes for the coming year will have changes. To understand the tax adjustments for 2023 in response to inflation, consider this guide.

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