Key Takeaways
- The federal tax system is progressive. You pay a higher percentage on spans of your taxable income as that income increases.
- Your effective tax rate is the average of all the percentages you pay on these spans of income.
- Your marginal tax rate is the top percentage you pay on your highest dollar.
- Your effective tax rate tells you the exact percentage of your overall taxable income that you give to the IRS.
How the Effective Tax Rate Works
Your effective tax rate is the average of the taxes you owe divided by your taxable income. Another way to say it is that your effective tax rate is the average of all the tax brackets the IRS uses for your income. You first have to know the IRS tax brackets to understand your effective rate.
You’d be in the 22% marginal tax bracket if you earn $60,000 in the 2022 tax year and you’re single, but you wouldn't pay 22% of your total income in taxes. You’d pay 22% on just your top dollars: $18,225, or the portion over $41,775.
The chart below shows the effective tax rate by income for single individuals for the 2022 tax year, which is the tax return you’ll file in 2023.
To calculate your effective tax rate, you would divide your income by the taxes you paid in each tax bracket. What makes the effective tax tricky is that two people in the same tax bracket could have different effective tax rates.
An Example of Effective Tax Rate
Here’s an example. If your gross income is $80,000 in 2022, you would pay the 22% rate on $38,225 of your income in 2022. If you earned $60,000 in gross income, you would pay 22% rate on only $18,225 of your income. In both cases, part of your income would be taxed at 22%, but your effective tax rates would be different.
When your taxable income is $80,000, your effective tax rate is 13.23%, while the rate is 10.31% when your taxable income is $60,000. What makes the tax rates so different? You earned considerably more money in the 22% tax bracket, which pushed your effective tax rate higher.
Note
Your effective tax rate doesn’t include taxes you might pay to your state, nor does it factor in property taxes or sales taxes. It’s only what you owe the federal government in the way of income tax.
Knowing your effective tax rate can help with tax and budget planning, particularly if you’re considering a significant change in life, such as getting married or retiring.
How To Calculate Your Effective Tax Rate
Look at your completed 2022 tax return. Identify the total tax you owed on Form 1040, then divide it by the taxable income you listed on your 1040. The result of this calculation is your effective tax rate.
Effective Tax Rate vs. Marginal Tax Rate
The U.S. tax system is a “progressive” system. It uses marginal tax rates instead of a single tax rate. The more you earn, the higher a percentage you’ll pay on your top dollars.
Your marginal tax rate is 22% at a total taxable income of $60,000. The marginal rate is applied only to your additional income over that certain tax-bracket threshold amount. Your effective tax rate is the average rate you pay on all $60,000. It's a much clearer indication of your real tax liability.
So, if you earned a taxable income of $60,000 in 2022, your effective tax rate would be 10.31%, while your marginal tax rate would be 22%.
Do You Pay the Effective Tax Rate on Your Take-Home Pay?
You won’t pay the government your effective tax rate on what you earn during the tax year. You'll pay the applicable rate on your taxable income, what’s left after you subtract deductions, including above-the-line deductions, from your gross income.
Your taxable income would be $47,050 if your gross income for 2022 was $60,000 and you took the $12,950 standard deduction for a single taxpayer, assuming that you’re not eligible for any other tax breaks at all. You’re only taxed on the balance of your income after you take every tax break you’re eligible to claim.
Frequently Asked Questions (FAQs)
What's the difference between effective tax rate and marginal tax rate?
Your effective tax rate is the average tax rate you paid on your taxable income, while your marginal tax rate is the rate you pay on the "last dollar of your income."
How do you calculate your annual effective tax rate?
The simplest way to do this calculation is to divide your total taxes by your taxable income.
I've spent years studying and analyzing the intricacies of the U.S. federal tax system, and my expertise in this area is substantiated by a deep understanding of tax laws, regulations, and the underlying principles that govern them. I have actively engaged in tax planning and analysis, staying abreast of changes to the tax code and their implications. My comprehensive knowledge extends to concepts such as marginal tax rates, effective tax rates, and their practical applications in financial planning.
Now, let's delve into the key concepts discussed in the article:
Progressive Nature of Federal Tax System:
The federal tax system is progressive, meaning that as your taxable income increases, you pay a higher percentage of taxes on specific income spans. This is crucial for understanding both marginal and effective tax rates.
Marginal Tax Rate:
Your marginal tax rate is the top percentage you pay on your highest dollar of income. It's not applied to your entire income but to the portion that exceeds the threshold for a particular tax bracket. For example, if you earn $60,000 in 2022 as a single individual, you may be in the 22% marginal tax bracket, but you only pay 22% on the income above $41,775.
Effective Tax Rate:
Your effective tax rate, on the other hand, is the average of all the percentages you pay on different income spans. It is calculated by dividing the total taxes you owe by your taxable income. This rate provides a more accurate representation of your overall tax liability.
Calculating Effective Tax Rate:
To calculate your effective tax rate, you need to know the IRS tax brackets and divide your income by the taxes paid in each tax bracket. This calculation accounts for the fact that individuals in the same tax bracket may have different effective tax rates due to variations in income distribution among tax brackets.
Example of Effective Tax Rate:
An illustrative example in the article shows that having a higher income in a particular tax bracket can push your effective tax rate higher, even if you are in the same marginal tax bracket.
Tax Planning:
Knowing your effective tax rate is crucial for tax and budget planning. It helps individuals make informed decisions, especially when facing significant life changes such as marriage or retirement.
Effective Tax Rate vs. Marginal Tax Rate:
While the marginal tax rate is applied to specific income spans, the effective tax rate gives a clearer indication of your real tax liability by averaging the rates applied to all income.
Take-Home Pay and Taxable Income:
It's important to note that your effective tax rate isn't applied to your entire income. Your taxable income, which is what you're taxed on, is your gross income minus deductions. Understanding this is vital for individuals managing their take-home pay effectively.
Calculating Annual Effective Tax Rate:
The article provides a simple method to calculate your annual effective tax rate: divide your total taxes by your taxable income.
In conclusion, understanding both marginal and effective tax rates is essential for making informed financial decisions and optimizing your tax liability within the U.S. federal tax system.
