Understanding Marginal vs. Effective Tax Rates

Oct 4, 2022 | Financial Planning, Tax & Accounting

Understanding marginal and effective tax rates are important for tax planning purposes; however, many taxpayers don’t fully understand the differences. Let’s take a closer look:

Marginal Tax Rate

The United States has a progressive tax system. The more money you earn, the higher your tax rate is and the more taxes you pay to the IRS. In 2022, there are seven tax brackets ranging from 10% to 37%. If you earn $35,000 a year as a single filer, you are in the 12% tax bracket. If you make $550,000 a year as a single filer, you are in the 37% tax bracket. These brackets represent the percentage of taxes you pay based on your taxable income and are referred to as marginal tax rates. When someone says they are in the 35% tax bracket, this is typically what they are referring to – and this is where the confusion begins.

For many taxpayers, their income is the same as their earnings from wages; however, taxpayers should note that income from capital gains may be taxed differently. Short-term capital gains are generally taxed as ordinary income subject to the seven tax brackets mentioned above. Long-term capital gains, however, are taxed at 0%, 15%, and 20%.

Due to the way, the tax code is set up and because marginal tax rates apply to each additional level of income above your tax bracket’s income limit, it is not as straightforward as it seems. If you earn $100,000 and are in the 24% tax bracket, it doesn’t mean that you pay a 24% tax on your earned income (0.24 x $100,000 = $24,000).

To illustrate how this works, let’s look at the following example for a single taxpayer earning $100,000 of annual income in 2022 (i.e., filing a tax return in April 2023). The amount of tax owed breaks down as follows:

    • 10% Bracket: ($10,275 – $0) x 10% = $1027.50
    • 12% Bracket: ($41,775 – $10,275) x 12% = $3,780.00
    • 22% Bracket: ($89,075 – $41,775) x 22% = $10,406.00
    • 24% Bracket: ($100,000 – $89,075) x 24% = $2,622.00

Total tax = $17,835.50

In the example above, the marginal tax rate (tax bracket) on $100,000 of income is 24%, but the effective tax rate is closer to 18% ($17,835.50/$100,000) – without taking any deduction that reduces taxable income.

Effective Tax Rate

The effective tax rate is the actual amount of federal income taxes paid on a taxpayer’s taxable income and more accurately represents the amount of tax most people pay. The effective tax rate does not include state taxes and local taxes, FICA taxes, or self-employment tax.

Many taxpayers take advantage of tax credits and deductions that reduce taxable income, such as the standard deduction, tax-deductible contributions to a retirement or pension plan, health savings account, tax credits for dependent children, and charitable contributions.

Calculating your effective tax rate is relatively simple: Divide your total tax liability by your gross (before tax) annual income. For example, if you made $100,000 (single filer), took the standard deduction of $12,950 in 2022, reducing your income to $87,050, and paid $14,768.00 in tax, the effective tax rate is closer to 15 percent even though you are in the “24%” tax bracket.

Questions?

If you feel like too much of your hard-earned money goes straight to the IRS instead of your bank account, please call the office to learn more about tax planning strategies that could save you money.

Recent Posts

Employee Retention Tax Credit (ERTC) Scams and Fraud

Employee Retention Tax Credit (ERTC) Scams and Fraud

The rise of "ERTC Mills" has caused widespread confusion and increased the potential for fraud. These entities exploit the system, intensifying the risk of deception. While these mills charge for basic clerical duties, their agreements often specify that they don't...

Minimizing Capital Gains Tax on Sale of a Home

Minimizing Capital Gains Tax on Sale of a Home

If you're looking to sell your home this year, then it may be time to take a closer look at the exclusion rules and cost basis of your home to reduce your taxable gain on the sale. The IRS home sale gain exclusion rule allows an...

Deducting Business-Related Vehicle Expenses

Deducting Business-Related Vehicle Expenses

If you're self-employed and use your car, SUV or other vehicle for business, you can deduct certain business-related vehicle expenses. Depending on the cost of operating the vehicle or how much you drive it, as well as how much of your use of the vehicle is for...

Call Now ButtonCall Now