Understanding the difference between these two tax rates
The tax code is filled with terms we rarely use in everyday conversation. Two of the more common are Marginal Tax Rates and Effective Tax Rates. Knowing what they mean can help you think differently about your potential tax obligation.
Marginal Tax Rate: This is the tax rate applied to the next dollar you earn. Since our income tax rates are progressive, the next dollar you earn could be taxed at as little as zero or as high as 37%!
Effective Tax Rate: This is the tax rate you actually pay. It is total taxes paid divided by your total taxable income. Said another way, after taking your income and then applying taxes, deductions, credits, exemptions, and other adjustments, you are left with your true tax obligation. This obligation is a percent of your income.
A Simple Example
Consider two single people; Joe Cool who earns $50,000 and Chuck Browne who earns $500,000. If we had a flat tax of 10%, Mr. Cool would pay $5,000 in tax and Mr. Browne would pay $50,000 in tax. Both of their Effective Tax Rates would be 10% AND their Marginal Tax Rates would also be 10% because each additional dollar they earn would be taxed at the same 10%. However it is a different picture when you apply our progressive tax rates:
If we use the 2022 U.S. tax table for a single filer, Joe Cool pays $6,617 and Chuck Browne pays $148,753 in federal tax. This is because tax rates applied to Joe Cool’s income are (10 – 22%) while Chuck's income over $50,000 gets Marginal Tax Rates of (22 – 35%). Ignoring other tax factors, our two taxpayers’ tax rates are:
So look at last year’s tax return and calculate your Effective Tax Rate. Then look at your income and determine the Marginal Tax Rate to be applied on your next dollar of income. Finally, if you anticipate an increase in earnings, consider forecasting the impact on your Effective Tax Rate.
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Mia Verc, CPA; Janice Papais, CPA
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