What is the Difference Between Your Marginal Tax Rate and Your Effective Tax Rate?

Have you heard the phrases “marginal tax rate” (or tax bracket) and “effective tax rate” and wondered what the distinction is between them? In order to explain the difference, it is first important to note that in the United States, we do not pay a flat tax – we are on a graduated system and therefore pay taxes in tiers.

Let’s say that you are a Single filer, and you have taxable income of $60,000 for the 2020 tax year. According to the IRS tax tables, that puts you in the 22 percent tax bracket – in other words, that is your marginal tax rate. Twenty-two percent of $60,000 is $13,200, but luckily, you don’t have to pay that much.  If you calculate the tax based on the 2020 IRS Tax Tables, the amount of tax is $8,990, which is less than the $13,200 based on the 22 percent marginal rate.

This scenario illustrates the difference between your marginal tax rate (tax bracket) and your actual effective tax rate. Even though you would be in the 22% bracket based on $60,000 of income, you do not pay 22 percent flat tax.  You would pay less than that since there is one bracket below your tax bracket: the 12 percent bracket. (There are really two for you math geeks: 12 percent and 0 percent.)

The rate that you actually pay in taxes is your effective tax rate. This rate is unique to you individually and is simple to calculate.  Just take your total tax liability and divide it by your taxable income. In our example, that would be $8,990 / $60,000 = just about 15 percent.  Compare that to the 22 percent marginal rate and it sounds pretty good! 

The effective rate is often more useful because it gives you an average rate you pay on all the money you make during the year. It is much more accurate in terms of gauging what you might owe based on your projected taxable income. In most cases, the effective tax rate is less than the marginal rate.

The marginal tax rate is still helpful to know for tax planning.  For example, you can get a feel for how much potential benefit you could receive from an additional deduction. For example, how much would you benefit from making a $6,000 IRA contribution?  Your taxes would be reduced by $1,320, or 22 percent of $6,000. Looking it up in the tax tables is another way to double-check the math and yields the same savings.  

Understanding the difference between your effective and marginal tax rates makes you a smarter taxpayer!