Today we’re going to talk about marginal versus effective tax rates. Although this might not sound like the most exciting topic you’ve ever heard, this is actually very important.
Why is it so important?
One reason is that we are really close to tax time. But also, small business owners tell me this is one of their big fears, because they don’t understand how taxes are calculated. Also, they are afraid of earning more money, because it will put them into another tax bracket and cause a big jump in the amount of taxes that they owe.
How does it work?
So let’s go ahead and dismantle this one. What is the marginal tax rate? What is the effective tax rate?
I’ll talk about the differences so you can better understand what they mean and how they impact you. But first, a quick little backstory. I’ll make it quick:
The U.S. is has a progressive tax system. That means if you earn less money, you are taxed at a lower rate. And the more money that you earn, the more taxes that you pay.
If you earn $9,500 a year, for example, you’ll be taxed at a federal rate of 10%. Or if you make, say $89,000, you’re taxed at a federal tax rate of 22%. So the marginal tax rate is the rate at which the next dollar that you earn is taxed. If I’m in the 22% tax bracket, for example, then the next dollar that I earn is taxed at 22%. If I’m right at the line between around the 22%, tax bracket and 29% tax bracket, the last dollar earned was at 22%. But the next dollar I earned is actually at 29%.
So it has these delineated tiers in the way in which your money is taxed. That then leads into what your actual effective tax rate is. Because while my next dollar may be taxed at 22%, the average rate that I’m taxed across all of my earned income is going to always be a lower rate.
Hopefully, I haven’t confused the crap out of you. Because I know those are some small differences.
But it’s really important, because many people are worried about earning more income. I spoke to someone recently who wasn’t taking on new gigs, because she worried about how much that would then cost her in taxes. So it’s a very real fear. And it’s something that’s very misunderstood.
Again, this is not super exciting, but it is very important: We need to do a much better job of explaining how the tax system in America works.That’s what I’m here for, to help take the complex topics and make them more digestible, more sexy and easier to understand.
How can we use this information come tax time? Some great tax calculators are available, as the Smart Asset Income Tax Calculator.
If you enter the amount of money you expect to earn, what state you live in, and any deductions or assumptions that you have, it will show you what your marginal tax rate is and what the next dollar is taxed at your effective tax rate, which is the average tax rate across all your income. And it will also show you how different taxes are broken down.
It will show you based on federal taxes, which is everything we’ve been talking about so far.
But there are also state taxes in some cases, or city taxes, in some cases for income tax. So that’s a very helpful tool to help you get a sense of what the difference between those two are, and also the different amount of taxes that you might owe in any given year.
So that’s it! Hope it was helpful. If you have any questions need clarification about areas I didn’t cover, put them in the comments below and I’ll get back to you.
This post was adapted from an episode of the Fireside Financials series. If you’d like to check out the video, you can watch it here!