What's the Difference Between Marginal and Effective Tax Rates?
How to figure out your rates, and which one matters more.
Editor's note: A version of this article was initially published on April 10, 2018. It is part of the 2020 Tax and IRA Guide.
Question: What is the difference between marginal and effective tax rates, and which is more important?
Answer: To explain the difference between "marginal" and "effective" tax rates, I'll first dispel a common misconception: All of the income you make is not taxed at one rate. For example, let's say I'm a single filer who makes $50,000 per year, which puts me in the 22% tax bracket. If I paid a flat 22% tax rate on my income, I'd owe $11,000. Yikes. But when I look up $50,000 in the IRS' 2019 1040 Tax Tables, I find that I only owe $6,864. Why is that?
We pay taxes in tiers. Single filers are taxed at a 10% rate on the first $9,875 of income, which is the upper boundary of the 10% tax bracket. The next $30,250 of our income--the amount from $9,875 to $40,125--is taxed at 12%. The next bracket, 22%, encompasses incomes ranging from $40,125 to $85,525, and so on, all the way up to the 37% bracket which begins at $518,400 for single filers and has no ceiling.
Continuing with my example, 22% is my marginal tax rate because my $50,000 in taxable income falls between the upper and lower boundaries of the 22% bracket. But only the last $9,875 I earn will be taxed at the 22% rate.
An effective tax rate, on the other hand, is more like the average tax rate you pay on all the money you make during the year. Most taxpayers' effective tax rate is lower than their marginal tax rate. To figure out your effective tax rate, take the amount of tax you owe (in dollars) from the 2019 Tax Table, and divide that number by your taxable income.
Using my example, I would owe $6,864 of my $50,000 salary in income tax. Therefore, my effective tax rate is 13.7% ($6,864 / $50,000).
Why Do Marginal Rates Matter?
As a taxpayer, the marginal tax rate--the tax rate you pay on the last dollars you earn--is usually quite a bit higher than your effective, or overall, tax rate. Why do we hear so much about marginal income tax rates when effective income tax rates are arguably a lot more relevant to us?
One thing you can do with your marginal tax rate is calculate the potential benefit of taking a tax deduction. Let's say I made a $6,000 contribution to a traditional IRA in 2019 (or anytime before April 15, 2020) and I'm eligible to deduct the full contribution from my taxable income. Because my income falls into the 22% marginal tax bracket, the $6,000 tax deduction I took translates into a tax savings of $1,320 ($6,000 x 0.22).