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effective-and-marginal-tax-rates

What’s the Difference Between Effective and Marginal Tax Rates?

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Sitting down and filing your taxes can already be an overwhelming experience for a taxpayer, add confusing financial terms to it and you’ll surely end up with a headache.

But understanding the difference between effective and marginal tax rates can be beneficial since it will help you clarify how much tax you owe based on your tax bracket and annual income.

Since the US uses progressive taxation, learning how to calculate your taxes will eliminate unexpected tax implications. If done right, you might even be able to figure out how to lower your taxable income.

What is the effective tax rate?

The effective tax rate is the average percentage of your income that you need to pay in your individual tax return. It’s composed of your earned income, like your wages, and unearned income like your savings account interest or stock dividends.

For businesses or corporations, the effective tax rate refers to the average rate they need to pay on their pre-tax profits.

Effective tax rate usually only refers to your federal income taxes, so it doesn’t include:

  • Federal Insurance Contributions Act (FICA) taxes
  • State taxes
  • Local taxes
  • Self-employment taxes
  • Property taxes

Other than that, you’ll be able to calculate your or your company’s tax burden for the year.

How do you calculate your effective tax rate?

Knowing how to calculate your effective tax rate can be handy so you can prepare how much tax you owe for the year or if you can expect any refund from the government.

Plus, calculating it will only take a few minutes you just need to remember to divide your Total Tax by your Taxable Income. You can find your Total Tax on your Form 1040 on line 24, and your Taxable Income on line 15.

For businesses, you can calculate your effective tax rate by dividing the total tax expenses by the company’s pre-taxed income.

What is the marginal tax rate?

The marginal tax rate is the rate you need to pay on each additional dollar of your income. Since the US uses progressive taxation, you’ll be taxed based on your income where the higher your earnings the higher your tax rate will also increase. So this means that lower-income earners will be taxed at a lower rate compared to those that earn a higher income.

Since marginal tax rates are divided into seven tax brackets depending on your income level, your last dollar will be taxed at a higher rate once your income increases. Your first dollar earned will still be taxed at the rate of the lowest income bracket, while the rest are taxed at the rate of the range that they fall into.

How do you calculate your marginal tax rate?

To get your marginal tax rate, you’ll have to break down your income according to the tax brackets and apply the tax rate to the portion of your income to which it belongs.

For your reference, below are the tax brackets and tax rates for the 2022 tax year:

Tax RateSingleMarried Filing JointHead of Household
10%$0$0$0
12%$10,275$20,550$14,650
22%$41,775$83,550$55,900
24%$89,075$178,150$89,050
32%$170,050$340,100$170,050
35%$215,950$431,900$215,950
37%$539,900$647,850$539,900

If you’re worried that expanding your income will result in higher taxes, an increased income won’t attract heavy tax rates once it hits a higher bracket. Since only the portion that fits the upper bracket will get taxed.

Differences Between Effective and Marginal Tax Rates

If you’re still unclear about the differences between effective and marginal tax rates, effective tax rates can give you a more accurate estimate of your tax liability compared to marginal tax rates. Effective tax rates are usually lower since marginal tax rates often depict the highest tax bracket of your earnings.

If you have a business, using the effective tax rate method will encourage you to grow your company since having a higher income would attract effective taxes. Compared to applying marginal tax rates having a higher income will also result in higher taxes to be paid.

Although one downside to the effective tax rate is won’t protect you if your income goes down since the tax rate also doesn’t decrease. While marginal tax rates are more forgiving since the tax rates decrease when your taxable income goes down.

Need help with your taxes?

If you have any questions or need clarifications about your effective or marginal tax rates, Lear & Pannepacker have a team of professional accountants. Whether you need help organizing your financial books or looking for financial advice, their experienced professionals are equipped to help you. For inquiries, get in touch with their team now.

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