What’s the Difference Between Effective Tax Rate and Marginal Tax Bracket?

Your taxable income determines your marginal tax rate.

Effective tax rate and marginal tax bracket might seem like complicated tax terms, but they’re simply two different ways to express how much you pay in taxes. The main difference between marginal and effective tax rates is that marginal rates apply to the last dollar of taxable income you earn, whereas effective tax rates apply to your entire income. Both tax rates might change based on whether your tax-filing status is married filing jointly, married filing separately, head of household or single.

What Is Effective Tax Rate?

Your effective tax rate is the percentage of your total income that you actually pay in income tax. Essentially, your effective tax rate is the average rate you pay on every dollar you earn. Whereas marginal tax rates are determined by the federal government, effective tax rates vary from individual to individual.

The first step in determining your effective tax rate is to calculate your total tax liability. Next, use an effective tax rate calculator to divide your tax liability by your total income. For example, if you end up owing $4,800 in taxes on a total income of $60,000, your effective tax rate is 8 percent or $4,800 divided by $60,000.

Learn: 9 Tips for Dealing With Back Taxes

Marginal Tax Rate vs. Effective Tax Rate

Your marginal tax rate is the rate of tax you pay on each additional dollar of taxable income that you earn. For 2018, there are seven tax rates:

  • 10 percent
  • 12 percent
  • 22 percent
  • 24 percent
  • 32 percent
  • 35 percent
  • 37 percent

But your marginal tax rate is not the amount you pay on every dollar you earn. If you’re in the 22 percent tax bracket, for instance, a portion of your income will be taxed at 10 percent, a portion will be taxed at 12 percent, and a portion will be taxed at 22 percent.

Your effective tax rate will always be lower than your marginal tax rate because your taxes are only calculated based on your taxable income, whereas your effective tax rate includes all of your income.

Say you earn $20,000 but only have $10,000 in taxable income. For 2018, that puts your marginal tax rate at 10 percent. But your effective tax rate is only 5 percent since you owe $1,000 in tax and had $20,000 in total income. How might this happen? If you put money in a tax-deferred retirement account like a 401k, you are still earning that money, but you do not pay taxes on the money you deposit until you withdraw it in retirement. This allows you to effectively cheat your tax bracket — legally.

What Is My Tax Bracket?

Tax brackets are closely related to marginal tax rates. But a tax bracket refers to a range of income attached to a particular marginal tax rate. For 2018, income from $0 to $19,050 is taxed at 10 percent for individuals who are married filing jointly, for example; thus, for 2018, 10 percent represents the marginal tax rate, and $0 to $19,050 delineates the 10 percent tax bracket. If you had taxable income between $19,050 and $77,400, you would be in the 12 percent tax bracket if married filing jointly.

Understanding your tax filing status and how tax brackets work can play an important role in tax planning. For example, if you’re about to jump into a higher tax bracket, you might try to find a way to defer some of your income to the following year so you can remain in a lower tax bracket in the current year.

Click to find out what tax bracket you’re in.

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