It’s that time of the year again. That time where we settle-up with the IRS. There is a lot to be said and asked about paying taxes and refunds. For example, how can some pay so little in taxes and yet make millions? How is that possible? It’s all about marginal and effective tax rates.
The highest tax rate in the land at present is 37%. How can someone that makes so much money pay less than that? In some cases, the money is unearned income and therefore, taxed as a capital gain, which is a different rate than the earned income tax rate. The top capital gains tax rate (for now) on long-term investments is 20 percent.
Closer Look at the Marginal and Effective Tax Rates
My point here is that you can’t just look at the marginal tax rate, which is a tax bracket rate applied to the last dollar you earn. You need to also look at the effective tax rate. The marginal tax rate is calculated by dividing the tax you owe by your taxable income amount. Because your earnings happen to fall into a certain tax bracket, does not mean that that’s the rate of tax you’ll pay. Most of us likely pay a lower overall rate of tax than what our tax bracket indicates we should. The reason for this is because our tax system is progressive, which is a good thing…maybe?
Marginal Tax Rate
Your marginal tax rate is the rate at which your last dollar and your next dollar of income are taxed. It’s not the rate at which all your dollars are taxed. It’s the maximum rate you pay on any of your dollars of taxable income based on tax brackets or rates. For example, according to the rules at the time of this writing, the marginal tax rates for single filers are 10%, 12%, 22%, 24%, 32%, 35%, and 37%.
The marginal tax rate only deals with the specific tax on your income. Other taxes such as Social Security taxes, self-employment taxes, alternative minimum taxes, and even penalty taxes on retirement plan distributions may be taxed. Additionally, there are also credits that you may benefit from, such as the child tax credit, the dependent care credit, or education credits.
Effective Tax Rate
These other taxes and credits will affect the marginal tax rate and help to determine your overall tax. This is where the effective tax rate comes into play. Your effective tax rate reveals the average rate of taxation for all your dollars. It’s your total tax obligation, including your income tax and any other additional taxes and/or credits, divided by your total taxable income.
Therefore, the effective tax rate is the amount of tax owed when all other government tax offsets or payments are applied, divided by the tax rate. Two people who have lots of tax offsets such as credits, other taxes, capital gains, or deductions may have a different effective tax rate than their marginal tax rates.
After all, is said and done, your effective tax rate will likely be higher or lower than your marginal rate. In taxes, one thing is constant…it depends. So, when dealing with tax rates, be clear on which tax rate you are talking and working thru. Contact me here if I can help you figure your tax rate.