Marginal Tax Rates, Effective Tax Rates, and Tax Brackets – What’s the Difference and Which is Most Important?

By now, just about everyone knows that the tax rates in 2018 differ from those in 2017. You may have even noticed that your paychecks are slightly larger than they were last year. Some of this may be coming from a raise associated with performance, or a promotion, but a portion of your increased pay is likely a direct benefit from the recently changed tax code. Regardless, deciphering exactly which rates were changed can be tough? With so many tax rates, it can be difficult to know which ones we should pay most attention to, and when. Should I really care about which tax bracket I fall into? How is my tax bracket determined, and does that percentage reflect the amount that I’ll eventually have to pay to the IRS? And how do “effective” and “marginal” rates affect my income? These are all questions that we’ll explore in the coming sections.

Effective Tax Rate

This is the simplest of all the tax rates, and the easiest to calculate as well. Your effective tax rate is simply the average amount that you pay to the IRS at the end of each year. To calculate it, just divide the actual amount that you pay in taxes, by your income for the year. If you only receive income by trading your hours for dollars (work a typical job), you can actually calculate your effective tax rate before tax day. Locate your most recent pay stub, and divide the amount that you paid in taxes by your gross income. This isn’t to say that if you receive rental income or derive revenue from other sources, that you won’t be able to estimate your effective tax rate before tax day – your calculation will just be a little more nuanced, but the process is still the same. Gather all of your financial information, figure out the total amount that you will pay in taxes for a given period, say a month, then divide by your total gross income. The difficulty will arise from accurately calculating property, business, and other taxes and income. In either case, you’ll notice that you can pull certain levers to lower the amount of taxes that you pay now. Most notably, your pre-tax deductions (retirement or otherwise), reduce your taxable income, and the amount that you’ll pay in taxes now. The overall effect is a reduction in your average or effective tax rate.

Marginal Tax Rates & Tax Brackets

Unlike effective tax rates, marginal tax rates are only concerned with the taxes that you will pay on each marginal or incremental dollar that you earn. You can also think of it as the percentage of the last dollar that you earn that will be sent to the IRS. Marginal Tax rates are a little more tricky to calculate than effective tax rates because it isn’t just a simple average. Rather, different portions of income are treated differently. For instance, assume that you make $1,000 per year. If you were dealing with your effective tax rate (say 20%), we could calculate the amount that you’ll pay by multiplying the $1,000 by 20%, and derive an end of year tax liability of $200. However, under the marginal tax rate system, this isn’t the case. Instead, your first $200 may be tax-free, the next $600 may be taxed at 25%, and your final $200 may be taxed at 35%. In this scenario, you’ll find that while your marginal tax is 35%, your effective tax rate is only 22% ($200*0% + $600*25% + $200*35%). This is actually the type of tax system that is currently implemented in the US, and this marginal system is what people are referring to when they talk about tax brackets.

Currently, In the US we have 7 different tax brackets. Which tax bracket you fall into will be determined primarily by two things – how much  money you make, and your tax filing status (single, married filing jointly, etc.) See the charts below to determine your tax bracket (charts per CNBC.com):

Filing Status – Single:

Filing Status – Married Filing Jointly :

Filing Status – Head of Household:

Which Should I Care About the Most?

Overall, you’ll want to be most concerned with your effective tax rates. Regardless of your marginal tax rate, you’ll want to employ various tax planning strategies to reduce the actual amount of taxes you pay at the end of the year, which directly impacts your effective or average tax rate. Consider that some of the wealthiest individuals in the world fall into the highest tax bracket, yet have an effective tax rate far below you or I. In 2011, stock picking genius and one of the richest people in world, Warren Buffett asserted that he paid a lower federal tax rate than his secretary, which led to the creation of the “Buffett Rule.” This was a rule proposed by the Obama administration that would impose a minimum 30% effective tax rate on any individual that earns more than $1 million in any given year. Why are some of the wealthiest people able to pay such low tax rates? It’s because they can control the timing, form (wage v. distribution/dividends), and other important factors regarding their income. Unfortunately, most us have limited control over these aspects. We will receive a paycheck every two weeks or so, for a predetermined rate, from our employers.

Hopefully, you now have a better understanding of the various types of tax rates that are commonly discussed and feel more comfortable using these rates to better plan for your financial goals. Still, have questions? Leave a comment below and we’ll help you sort through the differences.

Leave a Reply

Your email address will not be published. Required fields are marked *