What is the difference between effective and marginal tax rate

Understanding marginal and effective tax rates are important for tax planning purposes; however, many taxpayers don’t fully understand the differences. Let’s take a closer look:

Marginal Tax Rate

The United States has a progressive tax system. The more money you earn, the higher your tax rate is and the more taxes you pay to the IRS. In 2022, there are seven tax brackets ranging from 10% to 37%. If you earn $35,000 a year as a single filer, you are in the 12% tax bracket. If you make $550,000 a year as a single filer, you are in the 37% tax bracket. These brackets represent the percentage of taxes you pay based on your taxable income and are referred to as marginal tax rates. When someone says they are in the 35% tax bracket, this is typically what they are referring to – and this is where the confusion begins.

For many taxpayers, their income is the same as their earnings from wages; however, taxpayers should note that income from capital gains may be taxed differently. Short-term capital gains are generally taxed as ordinary income subject to the seven tax brackets mentioned above. Long-term capital gains, however, are taxed at 0%, 15%, and 20%.

Due to the way, the tax code is set up and because marginal tax rates apply to each additional level of income above your tax bracket’s income limit, it is not as straightforward as it seems. If you earn $100,000 and are in the 24% tax bracket, it doesn’t mean that you pay a 24% tax on your earned income (0.24 x $100,000 = $24,000).

To illustrate how this works, let’s look at the following example for a single taxpayer earning $100,000 of annual income in 2022 (i.e., filing a tax return in April 2023). The amount of tax owed breaks down as follows:

• • 10% Bracket: ($10,275 – $0) x 10% = $1027.50
  • 12% Bracket: ($41,775 – $10,275) x 12% = $3,780.00
  • 22% Bracket: ($89,075 – $41,775) x 22% = $10,406.00
  • 24% Bracket: ($100,000 – $89,075) x 24% = $2,622.00

Total tax = $17,835.50

In the example above, the marginal tax rate (tax bracket) on $100,000 of income is 24%, but the effective tax rate is closer to 18% ($17,835.50/$100,000) – without taking any deduction that reduces taxable income.

Effective Tax Rate

The effective tax rate is the actual amount of federal income taxes paid on a taxpayer’s taxable income and more accurately represents the amount of tax most people pay. The effective tax rate does not include state taxes and local taxes, FICA taxes, or self-employment tax.

Many taxpayers take advantage of tax credits and deductions that reduce taxable income, such as the standard deduction, tax-deductible contributions to a retirement or pension plan, health savings account, tax credits for dependent children, and charitable contributions.

Calculating your effective tax rate is relatively simple: Divide your total tax liability by your gross (before tax) annual income. For example, if you made $100,000 (single filer), took the standard deduction of $12,950 in 2022, reducing your income to $87,050, and paid $14,768.00 in tax, the effective tax rate is closer to 15 percent even though you are in the “24%” tax bracket.

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What Is a Marginal Tax Rate?

The marginal tax rate is the tax rate you pay on an additional dollar of income. In the United States, the federal marginal tax rate for individuals increases as income rises. This means that your marginal tax rate will likely be lower than your tax bracket.

This method of taxation, known as progressive taxation, aims to tax individuals based upon their earnings, with low-income earners being taxed at a lower rate than higher-income earners.

Key Takeaways

• The marginal tax rate is the tax rate paid on the next dollar of income.
• Under the progressive income tax method used for federal income tax in the United States, the marginal tax rate increases as income increases.
• Marginal tax rates are separated by income levels into seven tax brackets.

Understanding Marginal Tax Rate

Under a marginal tax rate, taxpayers are most often divided into tax brackets or ranges, which determine the rate applied to the taxable income of the tax filer. As income increases, the last dollar earned will be taxed at a higher rate than the first dollar earned. In other words, the first dollar earned will be taxed at the rate for the lowest tax bracket, the last dollar earned will be taxed at the rate of the highest bracket for that total income, and all the money in between is taxed at the rate for the range into which it falls.

Marginal tax rates can be changed by new tax laws. The current marginal tax rates went into effect in the United States as of Jan. 1, 2018, with the passage of the Tax Cuts and Jobs Act (TCJA). Under the previous law, the seven brackets were 10%, 15%, 25%, 28%, 33%, 35%, and 39.6%. The new plan, signed into law in Dec. 2017, keeps the seven bracket structure. However, adjustments were made to the tax rates and income levels.

Under the TCJA, the new rates are 10%, 12%, 22%, 24%, 32%, 35%, and 37%.

Marginal vs. Flat Tax

The other type of tax rate is the flat tax rate, which a few states implement for state income tax. Under this system of taxation, people aren’t taxed on a scale (like the marginal tax rate), but rather, flat across the board. In other words, everyone is charged the same rate, regardless of income level.

Most systems that use a flat tax rate do not allow for deductions and are seen in countries with a rising economy. Those who support this system of taxation describe it as fair, as it taxes all people and businesses at the same rate. Those who oppose it believe that it results in high-income taxpayers paying less than they should for an equitable society.

Marginal Tax Rate Example

The table below shows the rates and income levels for three types of filer in 2022: single, married filing jointly, and heads of household.

Individuals who make the lowest amount of income are placed into the lowest marginal tax rate bracket, while higher-earning individuals are placed into higher marginal tax brackets. However, the marginal tax bracket in which an individual falls does not determine how the entire income is taxed. Instead, income taxes are assessed progressively, with each bracket having a range of income values that are taxed at a particular rate. 

Under the current plan, if a single taxpayer earned $150,000 in taxable income, they would owe the following income taxes for 2022 (due in April 2023), as shown below:

• 10% Bracket: ($10,275 - $0) x 10% = $1,027.50
• 12% Bracket: ($41,775 - $10,275) x 12% = $3,780.00
• 22% Bracket: ($89,075 - $41,775) x 22% = $10,406.00
• 24% Bracket: ($150,000 - $89,075) x 24% = $14,622.00
• 32% Bracket: Not applicable
• 35% Bracket: Not applicable
• 37% Bracket: Not applicable

If you add up these amounts, the entire tax liability for this individual would be $3\29,835.50, or an effective tax rate of 19.9% = ($29,835.50 / $150,000).

The seven marginal tax rates of the brackets remain constant regardless of a person's filing status. However, the dollar ranges at which income is taxed at each rate change depending on whether the filer is a single person, a married joint filer, or a head-of-household filer. In addition, due to a provision in the tax code referred to as indexing, the dollar range of each marginal tax bracket typically increases annually to account for inflation.

What Is the Effective Tax Rate?

The effective tax rate is the percent of the income that an individual or a corporation pays in taxes. The effective tax rate for individuals is the average rate at which their earned income (such as wages) and unearned income (such as stock dividends) are taxed. The effective tax rate for a corporation is the average rate at which its pre-tax profits are taxed, while the statutory tax rate is the legal percentage established by law.

What Is the Difference Between Effective and Marginal Tax Rate?

The effective tax rate is a more accurate representation of a person's or corporation's overall tax liability than their marginal tax rate, and it is typically lower. When considering a marginal versus an effective tax rate, bear in mind that the marginal tax rate refers to the highest tax bracket into which their income falls. In a progressive income-tax system, like the one in the United States, income is taxed at differing rates that rise as income hits certain thresholds. Two individuals or companies with income in the same upper marginal tax bracket may end up with very different effective tax rates, depending on how much of their income was in the top bracket.

What Is a Flat Tax?

A flat tax, also known as a regressive tax, applies the same tax rate to every taxpayer regardless of income bracket. Typically, a flat tax applies the same tax rate to all taxpayers with no deductions or exemptions allowed, but proposals for allowing certain deductions are being considered. Most flat tax systems or proposals do not tax income from dividends, distributions, capital gains, or other investments.

The Bottom Line

The U.S. has a marginal tax rate system, whereby different tax brackets (with ever-increasing tax rates) kick in at different levels of income. This means that you are taxed at a certain rate for certain amounts of income that progressively get larger. So, if you make $1,000,000 a year and the tax bracket for that amount is 37%, you will not pay that percent on all one million dollars. Instead you will pay marginal rates for each tax bracket up to $539,900 of income (for single filers). Only the last $460,100 would be subject to the 37% rate.

Should I use marginal or effective tax rate?

What does a marginal tax rate mean?

What is an effective tax rate?

Why is the marginal tax always higher than the effective tax rate?