Categories
Taxes

What is the difference between marginal and effective tax rates?

Let’s say your and your spouse’s taxable income is $110,000 in 2020.

NOTE that your taxable income is calculated after all the tax deductions.

So your actual total earned income would be higher than $110,000. For the tax year 2020, we have the standard deduction of $24,800. Assuming you did not have any other deductions besides the standard deduction your gross income would be 134,800.

Now, this $110,000 is taxed in different chunks:

  • First, $19,750 is taxed at a 10% rate – the lowest federal tax bracket!
  • Then up to $80,250 is taxed at 12% rate – the next one higher….GOT IT?
  • Then the last remaining amount until $110,000 is taxed at 22%
    • Since 22% is your higher tax rate — it is also referred to as your marginal tax bracket!

If you are thinking of 401(k), IRA, or HSA deductions you should be looking at this marginal tax bracket to see how much you will save in taxes.

Your effective tax rate is different from the marginal tax bracket. It is the overall tax divided by the total income.

So in this example, this couple (MFJ above means Married Filing Jointly) are paying $15,780 in total taxes:

10% * ($19,750-$0) + 12% * ($80,250-$19,751) + 22% * ($110,000-$80,251)

TIP: Put this in excel or google spreadsheet or just regular 4th grade way of pencil and paper to get some practice in calculating total taxes this way!

So this couple‘s effective tax rate is = $15,780/$134,800 = 11.70%

Very frequently people get confused in these two tax brackets.

Leave a Reply

Your email address will not be published. Required fields are marked *