Marginal vs Effective Tax Rates And Why It Matters
During tax season I get a lot of questions about tax terms. Not surprising because taxes are historically known for being confusing. Marginal and effective are common terms that most people get wrong so I figured I would clear it up on this weeks post.
Marginal tax rate refers to the amount of tax that would be paid on an additional dollar of income. It's the rate at which the last dollar earned will be taxed. In other words, it's the tax rate applied to the next dollar of taxable income. This is based on your taxable income which is the number you see after taking the standard deduction or your itemized deductions from your gross total annual income.
Effective tax rate, on the other hand, is the average tax rate paid on total taxable income. It's calculated by dividing the total tax liability by the total taxable income. Unlike the marginal tax rate, which only considers the tax on an additional dollar of income, the effective tax rate considers the effect of tax deductions, tax credits, and other tax incentives, which can lower the overall tax liability.
For example, if you earned $100,000 and owed $25,000 in taxes, your effective tax rate would be 25% (25,000 ÷ 100,000 = 0.25). If your marginal tax rate was 35%, it would only apply to the portion of your income over the highest tax bracket threshold and not your entire income.
It's important to understand the difference between marginal and effective tax rates because they have different implications for tax planning and decision making. Marginal tax rates help determine the tax impact of an increase in income, while effective tax rates provide an overall picture of the total tax liability as a percentage of taxable income.
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