What are marginal tax rates and effective tax rates?

What are marginal tax rates and effective tax rates?

Have you ever wondered why your taxable income doesn’t lose the percentage of the tax that your bracket is in? This is because of the operating principles behind marginal tax rates. Because of graduated tax brackets that tax wealthier people more, the higher your taxable income is, a larger percentage of income will go to taxes. Your marginal tax rate is the rate at which the last dollar you earn is taxed, and your marginal tax bracket is the highest tax bracket you pay taxes in. You can find your marginal tax rate by seeing which marginal tax bracket you fall into and identifying the corresponding marginal tax rate.

Effective tax rate, on the other hand, is far simpler. The effective tax rate is simply what percent of your taxable income is actually taken as tax. It’s the average rate you pay for every dollar in your taxable income. However, the effective tax rate cannot be found without calculating your total taxes due.

Conceptualizing marginal tax rates

Still confused? Don’t worry, it’s a pretty simple concept that’s hard to put into words. Imagine you have different cups of different sizes and your money is water in a bucket you pour into the containers. First, you fill up the first tax bracket, and if your bucket still has water you move on to the next cup. Once you’ve filled up the third cup you move on to the fourth cup and so on until you either: run out of water or reach the last tax bracket, 37%. This tax bracket is special because it is the last one, think of this as a bottomless cup that you can never fill; you can only continue to pour the last of your bucket of water until you are out. The water (money) you put into the first cup will be taxed at the rate of the lowest bracket, the water in the second cup will be taxed at the rate of the second lowest bracket, and so on. Given that the cups are the different tax brackets, the sizes of the cups represent the range of those brackets. The ranges for tax brackets often change annually so it’s important to stay up to date.

An example with money

Say you make a gross income of $60,000 and are filing independently. Before any taxes can be applied, we must convert to taxable income by subtracting the standard deduction from the gross income.

This is done using the Standard Deduction, a built-in tax deduction of $14,600 for those filing independently. (The standard deduction amounts for 2024 are $14,600 for single filers, $29,200 for joint filers, and $21,900 for heads of household).

$60,000 (gross income) – $14,600 (standard deduction) = $45,400 (taxable income)

10% Bracket: The first $11,600 of income is taxed at 10% → 1,160 in taxes

12% Bracket: The next portion, from $11,601 to $45,400, falls in the 12% bracket. The amount in this range is $45,400 – $11,601 = $33,799.

• $33,799 taxed at 12% → $4,055.88 in taxes

Total taxes: $1,160 + $4,055.88 = $5,215.88

This individual does not have a taxable income high enough to reach the third tax bracket, therefore this individual has a marginal tax rate of 12% and has to pay a total of $5,215.88 in federal taxes.

Since the effective tax rate is calculated by dividing the taxes paid and your taxable income, we can now calculate it.

(Taxes paid / taxable income) x 100 = Effective tax rate (in %)

($5,215.88 / $60,000) x 100 = ~8.69% effective tax rate

Let a professional handle it

Both Marginal and Effective Tax Rates are important when it comes to making informed financial decisions and knowing how to efficiently manage your tax. A CPA or tax professional can help you use these numbers to minimize your tax liabilities, avoid tax violations, and provide financial advice.

Unfortunately, taxes aren’t usually this easy to calculate. Although the example may not have been difficult to understand, tax codes have many different classifications and changes depending on one’s circumstances, not to mention how often tax codes are debated in legislation which leads to an ever-changing tax code. Just one miscalculation could lead to a letter from the IRS. Leave it to the professionals and leave it to someone you can trust. Leave it to MANA CPA Services.

Written by: Namah Patel

Reviewed by: Meg Bhatt, CPA