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  • Nick Burgess

Marginal, Effective, and Actual Tax Rates: What's The Difference?

Understanding United States Tax Rates

When it comes to understanding taxes, it is important to understand not only the amount of taxes that you owe, but also the rate at which taxes are applied to your income. In the U.S, there are tax codes that could fill a Greek library, but you really need to understand the concepts of marginal tax rate, average tax rate, and effective tax rate. While these three tax rates may seem similar, they are actually quite different and can have a significant impact on how much in taxes you might pay at the end of a given tax year.

marginal, effective and actual tax rates

The Different Tax Rates

The Marginal Rate

The marginal tax rate is the rate at which taxes are applied to the next dollar of income earned. For example, if the marginal tax rate is 25%, then single filers or a business that earns an additional $100 in income will owe an additional $25 in taxes. The marginal tax rate can change depending on the amount of income earned and the tax bracket that an individual or business falls into. The U.S tax system is progressive, which means that as income increases, the marginal rate also increases at a higher rate. This is done to ensure that those who earn more pay a larger portion of their income in taxes, which is often seen as a way to reduce income inequality, though there are arguments that those in the highest tax bracket don't usually pay higher tax rates, but that's an argument for a different article.

It's important to note that the marginal tax rate is often higher than the average tax rate. This is because the marginal tax rate is only applied to the last dollar of income earned, while the average tax rate is applied to all income earned. Therefore, the marginal tax rate is often higher than the average tax rate, as it includes the taxes paid on the last dollar of income earned. This can have a significant impact on decision-making when it comes to things like investing or taking on additional income. For example, if an individual or business is considering taking on a new job that will bring in an additional $50,000 in extra income, they need to consider not only the additional income but also the additional taxes that they will owe as a result of that income. If the marginal tax rate is higher than the average tax rate, it may not be worth it to take on the additional income.


The Average Rate

The average tax rate, on the other hand, is the total amount of taxes paid divided by the total income earned. This means that it is the percentage of an individual or business's entire income that is paid in taxes. For example, if an individual or business earns $100,000 and pays $25,000 in taxes, their average tax rate would be 25%. The average tax rate does not change based on the total taxable income earned, as it is a fixed percentage of income. However, it is important to note that the average tax rate can be misleading, as it does not take into account the progressive nature of the federal tax brackets. This means that it does not reflect the fact that those who earn more pay a higher percentage of their income in taxes, known as the "progressive tax system."

The Effective Rate

The effective tax rate is the percentage of an individual or business's income that is paid in taxes after accounting for tax deductions, tax credits, and other factors that reduce the amount of taxes owed. This is the overall rate at which taxes are paid. It takes into account all the different tax rates that are applied to different levels of income, and it gives a more accurate picture of the total amount of taxes paid. For example, if an individual or business earns $100,000 and pays $25,000 in taxes, but also takes $10,000 in deductions, the effective tax rate would be 22.5%. The effective tax rate is often lower than the average tax rate and is often considered to be a more accurate representation of the overall tax burden for an individual or business based on their gross income and accounting for any credits under the federal tax code.


Taxes for Your Individual Situation

I want to make it abundantly clear that this article is not a guide for calculating your own taxes, and should not be used as a calculator to figure out your total tax liability. There are many, many factors that will determine your tax liability, which is why accounts are paid so much to pour through your documents. Things that could affect your tax liability include things like:

  • Filing status. Are you single taxpayer? Are you a married couple? Head of household? Each one of these provides a different standard deduction on your taxes, affecting your tax liability

  • Income sources like investment income, ordinary income, long-term capital gains, dividend income or side hustle income that could rocket you into a higher federal tax bracket

  • Do you live in a state with no state income tax?

  • Do you run a business and have payroll taxes to deal with?

In summary, understanding the difference between marginal tax rate, average tax rate, and effective tax rate is essential when it comes to managing your finances and making informed decisions about your income. However, understanding these terms is just the tip of the iceberg when it comes to your the picture of your total taxes. Make sure you are consulting a licensed professional to figure out your taxes, and a good accountant can usually figure out how to kick you down to a potentially lower rate of tax. Happy tax season!

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