If you stare blankly in confusion when reading the phrases “marginal tax rate” or “effective tax rate,” or can’t remember the difference between the two, a refresher might be in order, as knowing these terms can help with your financial planning.
Think of marginal tax rates as empty buckets
The U.S. has a graduated or progressive income-tax system, in which your income is taxed at differing rates as it rises past certain thresholds, or brackets. For the 2021 tax year, these are the tax rates as they correspond to your income, for an individual filer:
10% = Up to $9,87512% =$9,951 to $40,52522% = $40,526 to $86,37524% = $86,376 to $164,92532% = $164,926 to $209,42535% = $209,426 to $523,60037% = Over $518,400To help visualize how progressive taxes work, think of your taxable income as something that fills each tax bracket like a bucket. If you fill up the first bucket, the tax rate for that portion of income will get taxed at 10%. If you fill up the second bucket, the tax rate on the portion of your income in that bucket will be 12%, and so on, until you run out of income. This is what people mean by a graduated tax—you only get dinged the higher tax rates beyond a certain threshold (as an example, if you made $165,926, you’d squeak into the 32% tax bracket, but only $1,000 of that would actually be taxed at 32%).
Your marginal tax rate can guide your decisions about when to take deductions, especially if you’re right on the borderline of a tax bracket and want to minimize your tax exposure. As an example, you might place $10,000 into a tax-deductible 401(k) to avoid the 32% tax bracket, then withdraw the compounded sum later at a much lower tax rate—say, 12%—when you’re retired and aren’t bringing in as much income.
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Your effective tax rate covers everything
The effective tax rate, on the other hand, is based on the actual percentage of taxes you pay on all of your taxable income. To calculate your effective tax rate, you simply divide your total tax liability by your taxable income (this can be done using your 2020 Form 1040, by dividing the number on line 24 by the number on line 15). This rate will give you a clearer picture of how much of your income is actually being taxed, not merely which bracket you’re in. For example, your income could put you in the 22% tax bracket, but your effective tax rate could wind up being closer to 15%.
The effective rate can help you predict what you’ll need to save to pay your taxes later, and it’s also used as a benchmark by financial planners to compare strategies involving deductions and marginal tax rates. As CPA Tom Gibson recently explained to CNBC:
“The objective of tax planning is to minimize the taxes you pay not just this year but over many years and, ideally, over the course of your life. The savvy tax planner, like a corporate VP of Tax Planning, can reduce an individual’s effective tax rate.”
How to remember the difference between the two
If you find mnemonics helpful, think of Marginal Tax as “MT,” which stands for those “empty buckets” you need to fill. Effective Tax is “ET” for “everything tax”—meaning the overall tax rate for your total income.
