Did you know that the US tax system is a progressive system? This means that the taxes you need to pay is based on your annual income.
Marginal and effective tax rates will determine which tax bracket you are in.
This article will discuss differences, examples, and tax planning strategies to ensure you have the best outcome for your tax return.
Continue reading to learn about marginal vs. effective tax rates.
Contents
What is a Progressive System?
Marginal and effective tax rates are based on a progressive tax system. This system is designed to give a fair and equal opportunity to all involved.
A certain percentage is taken from the population’s income according to what they can afford to pay. This system introduces tax brackets with specific rates for each bracket. Governments often adjust these rates yearly due to inflations.
What Is a Marginal Tax Rate?
The marginal tax rate is used to calculate the next dollar of income. You may have heard of the first dollar vs. last dollar models, especially with college funding.
The same principle applies to a marginal tax rate. However, there are some differences. For example, your annual income puts you in a particular tax bracket.
Let’s say that you earned $41,000 last year. This would put you in the 22% tax bracket, but that doesn’t mean that you pay 22% on all of your income.
The first $9,950 puts you in the first tax bracket, so you would only pay 10% on that. The next bracket is 12%, with earnings between $9,950 and $40,252.
You would owe 12% on that amount of income. Finally, you would pay only 22% on the rest of the money, the remaining $748.
Example of Marginal Tax Rate
Let’s look at the example in-depth. This example is for a single tax filer, called John Doe.
- Annual income: $41,000 (22% tax bracket)
- First dollar: $0-$9,950 (10% tax bracket)
- Next dollar: $9,951-$40,525 (12% tax bracket)
- Last dollar: $40,526-$86,375 (22% tax bracket)
To determine John’s taxable income rate, we need to use the following formulas:
- First dollar: 0.10x$9,525=$952.50
- Next dollar: 0.12x$31,000=$3,720.00
- Last dollar: 0.22x$474.00=$104.28
- Total amount: $4,776.28
So instead of paying 22% of the total annual income, which would come to $9,020, John pays almost half because the first and next dollars fall into lower tax brackets and therefore have a lower tax rate.
Note that this example does not take into account the deductibles to avoid complications.
What Is an Effective Tax Rate?
An effective tax rate is a percentage that a person would pay in taxes. You would take the “Total Tax” and divide it by “Taxable Income” on your 1040 form to calculate this.
Effective tax rate, or ETR, is often a more accurate representation of what a person owes. However, it usually only takes federal income taxes into account. If you wish to calculate local and state taxes, simply add each to the federal total tax amount and divide it by the taxable income.
To calculate the total taxable income, subtract the standard deduction from your annual income. The standard deduction set by the IRS in 2021 is $12,550.
Example of Effective Tax Rate
Let’s take our previous numbers of John’s income and calculate the tax rate using the effective tax rate formula.
- Annual income: $41,000
- Taxable income: $41,000-$12,550=$28,450
- Total tax: $4,776.28
- ETR: $4776.28÷$28,450=16.8%
Marginal vs Effective Tax Rate: What Is the Difference?
In the first example, we saw that our John Doe falls into the 22% tax bracket. However, as soon as we calculated the progressive tax rate, meaning that the income in each bracket is calculated differently, we saw that instead of owing $9,020, the individual only owes $4,776.28.
With the effective tax rate, we saw that John actually falls into a different tax bracket; 16.8% instead of 22%.
Why Are These Numbers Important?
The marginal tax rate is important to know for tax planning strategies. Deductions, credits, and other items that affect your total income will reflect in these calculations.
For example, if you made ROTH IRA contributions, investments or are claiming deductions, your total income is lowered, putting you in a different tax bracket than your annual income states. This will allow you to determine whether you should make changes to your final return and lower taxes owed.
On the other hand, effective tax rates allow for comparing the differences between people, yearly tax returns, and the impact of certain investments or withdrawals.
Tax Brackets Explained
Now that you know that you fall into a certain tax bracket, it is crucial to understand what they actually mean.
For the years 2021 and 2022, the IRS assigned seven different tax brackets. Starting at $0 up to $532,600 and up.
For the 2021 tax year, the tax brackets for a single filer are:
- 10%: $0-$9,950
- 12%: $9,951-$40,525
- 22%: $40,526-$85,375
- 24%: $86,376-$164,925
- 32%: $164,926-$209,425
- 35%: $209,462-$523,600
- 37%: $523,601 and up
2021 tax brackets for married couples who are filing together:
- 10%: $0-$19,900
- 12%: $19,901-$81,050
- 22%: $81,051-$172,750
- 24%: $172,751-$329,850
- 32%: $329,851-$418,850
- 35%: $418,851-$628,300
- 37%: $628,301 and up
2022 tax brackets for a single filer:
- 10%: $0-$10,275
- 12%: $10,276-$41,775
- 22%: $41,776-$89,075
- 24%: $89,076-$170,051
- 32%: $170,051-$215,950
- 35%: $215,951-$539,900
- 37%: $539,001 and up
2022 tax brackets for a married couple filing together:
- 10%: $0-$20,550
- 12%: $20,551-$83,550
- 22%: $83,551-$178,150
- 24%: $178,150-$340,100
- 32%: $340,101-$431,900
- 35%: $431,901-$647,850
- 37%: $647,851 and up
Sometimes tax rate and tax bracket are terms used interchangeably. Although they are similar, there are some key differences between the two.
A tax rate is a percentage within the tax brackets. For example, 12% would be the rate, while $9,951-$40,525 is the tax bracket for a single filer for the year 2021.
The tax brackets make up the marginal rates, while the actual percentage, in John’s case, 16.8%, is considered the effective rate.
Tax Planning: Get the Most Out of Your Return
The first step to proper tax planning is understanding your bracket. Now that we have sufficiently covered that, let’s dive into how you can save money.
Once you discover your tax bracket, you can look at deductions and credits. While many think that they are similar, they impact your income differently.
Deductions and Credits
Tax deductions are expenses that you can, you guessed it, deduct from your annual income. Deductions can include medical expenses, charity donations, sick leave credits, student loans, alimony payments, IRA deduction, and more!
Before you file your taxes, you can check in with professionals to see if you qualify for more deductions.
Credits, on the other hand, can reduce the amount you owe on your tax return. Credits can include medical, education, homeowner, and savings credit.
As you can see, there is a slight difference between the two. Deductions lower your overall income, possibly putting you in a different tax bracket.
On the other hand, credits will lower your overall bill, and you may even receive money back due to the credits.
Standard Deduction vs. Itemizing
We mentioned standard deduction, which is over twelve grand for the tax year 2021. The IRS offers this deduction to streamline the process.
Individuals prefer this process as it eliminates the need of keeping and filing each receipt. However, if your itemized deductions are higher than the standard deduction, you may be better off putting in the extra work.
Itemized deductions can include mortgage interest, property taxes, and medical bills.
Invest in Your Future
There is an aspect to taxes that you can look at as an investment into a company if the company was the government. The more money you put in, the larger your ROI, or return on investment. However, each person is different and has individual needs.
Check out some ways you can save money below.
W-4
W-4 is the employee withholding certificate. This is the portion of your paycheck that goes directly to the IRS submitted by your employer on your behalf. The more you pay over the year, the less you owe on your final tax bill.
If you notice that your tax bills are high, you can increase your W-4. However, if you are struggling to make ends meet during the year, but once taxes come around, you receive a significant rebate, you should decrease it as well.
401(k) and IRAs
Putting money in a 401(k) will also give you a tax break. In 2021, you can place close to $20,000 into this account. This money is then out into your chosen investments.
The money that you put into the account is not taxable. As a result, it will lower your effective tax rate.
The difference between a 401(k) and an IRA is that your employer does not sponsor the latter.
IRA, or individual retirement plan, has two different accounts; traditional and Roth. You pay the taxes up front with a Roth IRA, but the investments are tax-free. A traditional IRA is tax-deductible, but you pay taxes when you take the money out of the account when retired.
Plan for the Future Generation
If you are able to set up an account for your children’s education, it is a great way to reduce your annual income. In addition, a 529 account will offer more benefits than a regular savings account.
However, it is no longer tax-free if you use the money from a 529 account other than educational expenses.
Marginal vs. Effective Tax Rate: Know the Difference
A marginal vs. effective tax rate will give you an understanding of how you can improve your tax bill and see how much you actually owe. You need to know how both rates work to lower your taxes and create an effective tax planning strategy.
Are you looking for more tax-saving tips? Keep browsing our taxes category for more information.
Learn More
Tax Free Retirement Account (TFRA): What Is It and How Does It Work?
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