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.
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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% or $4,800 divided by $60,000.
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. The IRS has announced six marginal tax rates for tax year 2021:
- 10% for incomes of $9,950 or less ($19,900 for married joint filers)
- 12% for incomes over $9,950 ($19,900 for married joint filers)
- 22% for incomes over $40,525 ($81,050 for married joint filers)
- 24% for incomes over $86,375 ($172,750 for married joint filers)
- 32% for incomes over $164,925 ($329,850 for married joint filers)
- 35% for incomes over $209,425 ($418,850 for married joint filers)
But your marginal tax rate is not the amount you pay on every dollar you earn. If you’re in the 22% tax bracket, for instance, a portion of your income will be taxed at 10%, a portion will be taxed at 12%, and a portion will be taxed at 22%.
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 2021, that puts your marginal tax rate at 12%. But your effective tax rate is only 6% since you owe $1,200 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 401(k), 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 2021, income from $0 to $19,900 is taxed at 10% for individuals who are married filing jointly, for example; thus, for 2021, 10% represents the marginal tax rate, and $0 to $19,900 delineates the 10% tax bracket. If you had taxable income between $19,900 and $81,050, you would be in the 12% tax bracket if married filing jointly.
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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.
This article is part of GOBankingRates’ ‘Economy Explained’ series to help readers navigate the complexities of our financial system.
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Daria Uhlig contributed to the reporting for this article.