Knowing your marginal tax rate and effective tax rate is important to be able to manage your finances properly. Each rate gives you different information about how much you are paying in taxes and can assist you in making wise investment, income, and tax planning choices. What marginal and effective tax rates are, how they are determined, and why they are important to your financial planning will be discussed in this article.
Definition and calculation of marginal tax rate
Marginal tax rate is the rate with which your last dollar of tax-inclusive income is taxed. It is the top tax bracket that your income enters. The United States federal income tax is progressive, that is, the higher your income, the higher your marginal tax rate. There are seven brackets of tax and corresponding marginal tax rates from 10% to 37%.
To determine your marginal tax rate, you need to identify the highest tax bracket your income falls into. For example, if you are single and have a taxable income of $100,000, your marginal tax rate is 24% because your income falls in the 24% bracket.
How marginal tax rates work
Marginal tax rates are applied to only the income in a bracket, not the overall income. What this amounts to is that only the income over a particular amount is charged at the increased rate. As an example, if you earn $100,000 and the 24% bracket starts at $100,525, then only income in excess of $100,525 would be taxed at 24%, but as your income falls short of that, your marginal rate is still 22%.
Understanding effective tax rate
Your effective tax rate is your overall tax rate on your overall taxable income. It gives a better approximation of your overall tax burden than your marginal tax rate. You can calculate your effective tax rate by dividing your overall tax cost by your taxable income.
For instance, if your overall taxable income is $60,000 and your total tax liability is $15,000, then your effective tax rate would be 25% ($15,000 / $60,000).
Importance of effective tax rate
Effective tax rate serves to help you grasp the dollar value of income you are paying in taxes in total. It may be lower than your marginal tax rate due to deductions and exemptions lowering your taxable income. The rate serves financial planning purposes because it illustrates to you in straightforward terms the true cost of your taxes.
How to calculate your marginal and effective tax rates
- Compute your taxable income: Compute your gross income reduced by any deductions.
- Determine your filing status: Classify yourself as single, married filing jointly, or head of household.
- Ascertain your tax bracket: Refers to the IRS tax tables to determine which bracket your income falls in.
Steps to determine effective tax rate
- Compute your total tax liability: This appears on your tax return (Form 1040, line 24).
- Calculate your taxable income: This appears on Form 1040, line 15.
- Divide total tax by taxable income: This calculates your effective tax rate as a percentage45.
You need to know both your marginal and effective tax rates in order to make effective financial planning. Your marginal tax rate allows you to estimate the tax impact of an extra dollar of income, while the effective tax rate gives you a general idea of your overall tax burden. By determining these rates, you are able to make investment, income strategy, and tax planning decisions to improve your financial circumstance. Whether or not you’re a seasoned investor or just learning how to plan for your money, an awareness of these rates will enable you to better move around the complexities of the U.S. tax code.
Read more: IRS2Go: where to download and how the IRS app works to file taxes online and get refunds faster
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