Let’s face it, the tax code isn’t always easy to comprehend. All of those rules, deductions, and lingo can get pretty complicated when you get right down to the definitions and distinctions of the many regulations within our tax laws. One of the more confusing components that trips up average taxpayers is the difference between the effective tax rate and the marginal tax rate.
As daunting as it may seem, we’re going to make things a little easier to understand by exploring both the effective and marginal tax rates to better understand what makes them different and how that affects your taxes. Before we get to all of that, it’s important to know that our laws are designed to support a progressive tax comprised of seven tax brackets ranging from 10% to 39.6%. The more money you earn over the course of the year, the higher your tax bracket.
The brackets are 10%, 15%, 25%, 28%, 33%, 35%, and 39.6% at the highest bracket, for those earning anywhere from $235,351 to $470,701 based on your filing status. Keep in mind that these brackets are only applicable to the amount of your taxable income, which means that these rates only apply after exemptions, deductions, and any other amounts that you are entitled to claim are subtracted from your taxable income.
Tax credits, on the other hand, are applied to your finances only after your income tax has been determined. Some credits are “refundable” in that they can be taken as part of any refund that you might be due, while others may not be accepted if you are getting a refund. These credits may only be taken as long as you still owe money to Uncle Sam. In any event, it’s important to understand this facet of the equation because your taxable income will almost always be less than your gross income.
The way that the tax code is currently written, taxpayers have a wide variety of options to help them lower the amount that they might owe each year but since our taxation structure works on a progressive slope the tax rate will increase along with how much you make each year.
Effective Tax Rate
The “effective” tax rate is defined as the average rate that any individual taxpayer or corporation is taxed on their income or profit. But there is a difference. For individuals, the effective tax rate applies to earned taxable income. For corporations, the effective tax rate applies pre-tax profits. In both cases, the effective rate is the average that an individual or a corporation is taxed on their money.
Calculating the effective tax rate on individual taxpayers is done by using Form 1040. Divide the total tax expense (located on line 63) by the amount of taxable income (located on line 43). For corporations, the effective tax rate can be calculated through dividing the total tax expense by the company’s earnings BEFORE taxes.
Taxes Incorporated into the Effective Rate
As the effective tax rate is predicated upon income tax and not other taxes such as sales tax or property tax, some taxes such as payroll tax can be included. Doing so can be helpful in making a comparison between the effective tax rate of multiple taxpayers. But since income tax is only one facet incorporated into the total tax that is paid out by taxpayers each year, the best way to calculate the effective tax rate is by adding up all of the applicable taxes that that a taxpayer is responsible for meeting and then divide that total by the income of the taxpayer for that tax year.
Marginal Tax Rate
To determine the marginal tax rate we have to go back to those seven tax brackets that we have previously discussed. Your marginal tax rate is defined by the percentage within every tax bracket that applies to your income for the tax year. The rate is calculated by the percentage of each applicable bracket taken from the next dollar that you may claim in a higher bracket over that pre-defined income threshold.
In the case of a marginal tax rate, a variety of taxes are included, such as federal, state and local, federal payroll and self-employment taxes. But the marginal will differ from the average tax rate that refers to the amount of taxes you pay based upon a percentage of your total income earned for the year.
The marginal tax rate and your actual tax rate will differ since you don’t pay the marginal rate based on your full income. It is only determined after you take into account exemptions, deductions, tax credits, and the thresholds that define each of the seven tax brackets. We’ve already established that our tax system is based on a progressive structure, which means that the marginal tax rates are going to increase with every tax bracket.
The Tax Brackets for 2017
For the purposes of simple illustration, these are the tax brackets and the income thresholds that pertain to a single filer for 2017.
- 10%: $0 to $9,325
- 15%: $9,326 to $37,950
- 25%: $37,951 to $91,900
- 28%: $91,901 to $191,650
- 33%: $191,651 to $416,700
- 35%: $416,701 to $418,400
- 39.6%: $418,401 or higher
These are the marginal tax rates that apply to all individual taxpayers, the more you make, the higher your bracket. But there is a common misconception about how these percentages are applied to an individual’s income. The important thing to understand is that your entire income is not taxed at one percentage or bracket. Your income is taxed at the percentage of each threshold that applies to your income amount.
For example, let’s say you made $82,500. You’re not getting taxed at 25% on that entire amount as a whole. In reality, you would be taxed 10% on the first $9,325 of your income, then 15% of the amount that falls within the $9,326 to $37,950 threshold, and 25% on the income that falls within the $37,951 to $91,900 threshold. It would work out as follows:
- 10% x $9,325 = $932.50
- 15% x $28,624 = $4,293.60
- 25% x $44,529 = $11,132.25
Total tax owed = $16,358.35
The marginal tax rate is also critical for doing proper financial planning. Knowing what the marginal tax rate is will allow you to make smart, well-informed decisions about how much you should contribute to a retirement account with distinct tax benefits or figure out how much you’ll get to keep from a raise at work or an end of year bonus from your employer.
The Effective Tax Rate and the Marginal Tax Rate
So now that we’ve reviewed each one, how do they relate to or differ from one another? We’ve established that the marginal tax rate relates to the tax bracket or brackets in which your income or the income of a corporation applies. As we’ve seen it could be as few as one or as many as seven, all based on how much income or profit has been taken in over the course of the year.
However, the effective tax rate is the more realistic interpretation of what you owe in taxes. Consider the incomes of two individuals based on the tax brackets for 2017. Person A made $50,000 and Person B made $38,300. They would both be taxed 10% on the initial $9,328 of their income and taxed at 15% on the next $28,624, and since they made enough income to reach the 25% bracket, that portion of their income will be taxed the same.
But for Person A that remaining income being taxed at 25% equals $12,051 and the remainder for Person B is just $351. That comes out to $3012.75 in taxes on the 25% portion for Person A and a scant $87.75 for Person B. All totaled up, Person A would pay $8,238.85 in taxes and Person B would pay $5,313.85. So while both individuals would top out in the 25% tax bracket, Person A is paying a tax rate of 16.4% and Person B is paying a tax rate of 13.8%.
Therefore, 16.4% and 13.8% is the effective tax rate for Person A and B respectively, while the marginal tax rate would be 25%. That is the difference between the effective and marginal tax rate.
For further clarification, the effective tax rate of Person A is 16.4%, which is the rate that accurately represents how much was actually paid on Person A’s income for the year. That is the rate you and I are more likely to be concerned with since that is the percentage of our money we are giving to the government.
The marginal tax rate is the rate by which every dollar you have made is being taxed each year. Those are demonstrated by the thresholds that are laid out in each bracket based on filing status. Single filers are taxed at 10% up to $9,325 and every dollar after that up until $37,950 is taxed at 15%, and so on. Those thresholds change for married couples filing separately or jointly and those who are filing as head of household.
These rates are just as important to care about as well since they do have a dramatic impact on your effective rate. There have been some proposals to change the tax rates by politicians who feel that the tax codes are too complicated and arbitrary and marginal rates do change over time. There used to be just five brackets at one time, now we have seven. These changes do affect the amount you pay in taxes but in order to get the most precise representation of what you pay out each year, the effective rate is the one that should be considered instead of the marginal rate.
So be sure that when you prepare your taxes that you identify all of your deductions and exemptions and the hundreds of various methods towards lowering your taxable income. It may leave you in a lower tax bracket and you could be paying less, but it may not necessarily mean you’re paying less than someone else. Always do your homework and when in doubt or if you’re still confused, consult with a tax professional to help you understand everything you need to know.