Effective Tax Rate vs. Marginal Tax Rate

Taxpayer calculating his effective tax rate

It’s no secret that the tax code from the IRS can be confusing, and tax rates are one of the most frequently misunderstood aspects. Filers who misinterpret marginal and effective tax rates can end up believing they have to pay more in taxes, which isn’t the case. Here are the key differences between the two.

What is a marginal tax rate?

In the United States, our government exercises a progressive tax system, which means the higher your income, the higher your tax rate will be. A marginal tax rate is the amount of tax that applies to each additional level of income.

Under the Tax Cuts and Jobs Act of 2017, taxpayers are divided into seven brackets: 10%, 12%, 22%, 24%, 32%, 35% and 37%. These percentages are your marginal tax rates.

The most common misconception with marginal tax rates is that X% of your entire income is owed to the government, depending on which tax bracket you’re in. But that’s not how tax brackets work:

For example, let’s say you’re a single filer and your annual income is $32,000. You decide to take the standard deduction ($12,000), which would lower your taxable income to $20,000. This would put you into the 12% tax bracket. Instead of handing over 12% of your $20,000 taxable income to Uncle Sam, you actually only pay 12% of the money over $9,525 – the 12% bracket’s minimum amount.

Here’s why: In the first bracket – 10% – you would pay 10% of the bracket’s maximum amount.

  • 10% of $9,525 = $952.50

Once you get to the 12% tax bracket, you’ll only have to pay 12% of $10,475 because that’s the amount of money you have left in your taxable income of $20,000.

  • 12% of $10,475 = $1,257

If you have a higher income such as $100,000, you would repeat the same process for each bracket until you reach your marginal tax rate – 24%.

What is an effective tax rate?

An effective tax rate is the actual percentage of your annual income that you owe to the IRS. To calculate your effective tax rate, you must divide your total tax liability by your annual income. When you add up the amounts from the example above, your total tax liability would equal $2,209.50, but since the IRS rounds up, it would actually be $2,210. Divide that number by your income before taxes ($32,000) and you’ll get an effective tax rate of 6.90%.

Now, you’ll also need to factor FICA taxes – Medicare and Social Security – into the equation, as well as any state and local taxes.

For our example, let’s say you don’t owe state or local taxes, so you’ll have to pay 7.65% of your taxable income for FICA taxes.

TaxSlayer can help

Whenever you prepare your taxes, keep in mind that the marginal tax rate is the highest tax rate that applies to a portion of your income, while the effective tax rate is the actual percentage you pay on your taxes. When you file with TaxSlayer, we do all the math for you to make your filing experience as easy as possible.

The information in this article is up to date through tax year 2021 (taxes filed 2022). 

This article is intended to provide general information to the public and does not provide personalized tax, investment, legal, or business advice. You should seek the assistance of a professional for advice on taxes, investments, and any other financial, legal, or business matter pertinent to your individual situation.

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