The difference between your effective tax rate and your marginal tax rate – and how they are both calculated – are questions that many people have come tax time. With tax season well underway, it’s more than likely that you also have these burning tax questions. Before jumping into calculating both rates, however, it’s crucial that you understand the differences between the two and what it means for your overall tax picture.
Here’s what you need to know to help you better understand the difference between the effective tax rate and marginal tax rate as well as how your effective tax rate is calculated.
What Is an Effective Tax Rate?
Under tax reform, five of seven marginal tax rates were lowered by 1% to 4%. The new rates are now 10%, 12%, 22%, 24%, 32%, 35% and 37%. When it comes to calculating how much tax you have to pay, there is a common misconception that what you are required to pay is based on the marginal tax rate that coincides with your tax bracket and your entire income.
For instance, if you are single and earn $50,000, you may be thinking the taxes you owe are calculated simply as 22% of your entire $50,000 in income since you fall into the 22% tax bracket. However, keep in mind that your tax liability is based on your effective tax rate and not the 22% marginal tax rate. So, just what is the effective tax rate? Because we have a progressive tax system in the U.S., not all of your income is taxed at the one marginal tax rate tied to your tax bracket. In a progressive tax system, your income is taxed at different rates at different income thresholds, so the effective tax rate gives you a more accurate picture of the taxes you’re paying since it is essentially an average of tax rates rather than your entire income tied to one tax rate.
How Do You Calculate Your Effective Tax Rate?
The first thing you should know regarding the calculation of the effective tax rate is that it is based on your taxable income, which is your income after the standard deduction ($12,400 single, $18,650 head of household or $24,800 married filing jointly) or itemized tax deductions, above-the-line adjustments to income and the 20% qualified business income deduction (if you are self-employed) are taken into account.
Since our tax system is progressive, increments of your taxable income are taxed at different tax rates all the way up to your top marginal tax rate for your income tax bracket, and only a portion will be taxed at the top tax rate for your income. For example, if you are single and your taxable income was $50,000 in 2020, $9,875 will be taxed at 10%, income from $9,876 to $40,125 will be taxed at 12%, and the rest will be taxed at 22%. Your effective rate would be your total tax results divided by the taxable income of $50,000. Another way to figure out your effective rate is to take the total tax and divide it by your taxable income.
If you sold long-term investments and had a gain, one thing to remember is you have long-term capital gains and you will not be taxed at the same rates. You will be taxed at lower rates (0%, 15% or 20%) based on your income. If you sold investments that you held for less than a year and had a gain, then your short-term capital gains will be taxed as ordinary income.
The Difference Between Marginal Tax Rate and Effective Tax Rate
Now that you understand what the effective tax rate is and how you are actually taxed, it’s time to understand the difference between the effective tax rate and the marginal tax rate. The effective tax rate is like an average tax rate at which income is taxed and more accurately represents the amount of tax you pay. The marginal tax rate, however, depends on your taxable income within the seven tax brackets (10%, 12%, 22%, 24%, 32%, 35% and 37%) and represents the highest tax rate that a taxpayer’s income falls into, so the effective tax rate is typically lower.
Knowing the difference between effective tax rate and marginal tax rate can help you understand how valuable tax deductions and credits can be to your bottom line and the amount of taxes you pay.