Understanding the Difference Between Marginal Tax Rates and Effective Tax Rates

One of the most misunderstood income tax concepts is the difference between the marginal tax rate and the effective tax rate.  Understanding the difference is crucial to making smart tax strategy decisions.

In the U.S. we have what’s called a progressive income tax, which simply means the more money you make, the more money you might have to pay in taxes. There is a bracket system in place to make our income tax progressive and is the reason why the concepts of effective tax rates and marginal tax rates are so often misunderstood.  Below is listed the new tax brackets resulting from the Tax and Jobs Act signed into law in December 2017.

Rate       Individuals                      Married Filing Jointly

10%        Up to $9,525                    Up to $19,050

12%        $9,526 to $38,700            $19,051 to $77,400

 22%       38,701 to $82,500            $77,401 to $165,000

24%        $82,501 to $157,500        $165,001 to $315,000

32%        $157,501 to $200,000      $315,001 to $400,000

35%        $200,001 to $500,000      $400,001 to $600,000

37%        over $500,000                  over $600,000

As Example: A person filing taxes as an individual beginning in 2018 would have their first $9,525 of income taxed at 10%.  Earnings over $9,525 up to $38,700 are taxed at 12%, and so on. The bracket system often leads to people believing that all of their income is taxed based on rate taken from the bracket where their income matches. But this does not mean that all of this individual’s income is going to be taxed at 22%.  It just means that their marginal tax rate is 22%.

So, if the individual in our example earns $60,000 in salary, they may believe that they are in the 22% tax bracket.  In reality, the first $9,525 is taxed at 10% ($952.50), the next $29,175 is taxed at 12% ($3,501.00), and the remaining $21,300 is taxed at 22% ($4,686.00)

Salary (Income)                Tax Rate              Tax Liability

$ 9,525                                  10%                        $ 925.50

$29,175                                 12%                        $3,501.00

$21,300                                 22%                        $4,686.00

$60,000                                                                 $9,112.50

What is a Marginal Tax Rate?

What is an Effective Tax Rate?

In our example above, taxes owed ($9,112.50) divided by taxable income ($60,000) is equal to 15.1%, making effective tax rate is 15.1%.

Knowing the difference between these two concepts is crucial for making good tax strategy decisions. Many people believe their effective tax rate is much higher than it actually is because they focus on their marginal tax rate.

The Tax Cuts and Jobs Act of 2017 represents the most significant changes in tax law in over 30 years!  These changes will impact virtually every aspect of tax filing, including all sorts of formerly allowable deductions. As your tax professionals, Capital Advisory Group Inc. is up to date on all these changes so that you can be assured the best possible tax strategy advice and preparation, whether you’re filing as an individual, a sole proprietor, or a corporation. Give us a call today at 636-394-5524 and let us help guide you through the complexities of these new rules.