How to Remember the Difference Between Effective and Marginal Tax Rates
If you are confused by the phrase “marginal tax rate” or “effective tax rate”, or you cannot remember the difference between the two, you may need to remember these terms, as knowing these terms can help in your financial planning. …
Think of marginal tax rates as empty buckets
The United States has a graduated or progressive income tax system whereby your income is taxed at different rates when it exceeds certain thresholds or parentheses. For tax year 2021, these are the tax rates that match your income for the Sole Payer:
- 10% = up to $ 9875
- 12% = $ 9,951 to $ 40,525
- 22% = $ 40,526- $ 86,375
- 24% = $ 86,376-164,925
- 32% = $ 164,926 to $ 209,425
- 35% = from $ 209,426 to $ 523,600
- 37% = more than $ 518,400
To visualize how progressive taxes work, think of your taxable income as something that fills every tax category like a bucket. If you complete the first basket, the tax rate for that portion of the income will be taxed at 10%. If you fill out the second basket, the tax rate on the portion of your income in that basket will be 12%, and so on, until you run out of income. This is what people mean by differential tax: you only get higher tax rates above a certain threshold (for example, if you earned $ 165,926, you would fall into the 32 percent tax bracket, but actually only $ 1,000 out of of this amount will be taxed at 32%).
Your marginal tax rate can guide your decisions about when to deduct, especially if you are on the borderline and want to minimize your tax risks. For example, you can put $ 10,000 in a 401 (k) tax-free amount to avoid the 32 percent tax category, and then withdraw the cumulative amount later at a much lower tax rate – say 12% – when you are retired and staying. satisfied. bring in the same amount of income.
Your effective tax rate covers everything
On the other hand, the effective tax rate is based on the actual percentage of taxes you pay on all of your taxable income. To calculate the effective tax rate, you simply divide your total tax liability by your taxable income (you can do this using the 2020 Form 1040 by dividing the number on line 24 by the number on line 15). This rate will give you a clearer idea of how much of your income is actually taxed, not just which group you are in. For example, your income might put you in the 22% tax bracket, but your effective tax rate might change. approaching 15%.
The effective rate can help you predict what savings you will need to pay taxes in the future, and is used by financial planners as a benchmark for comparing strategies that include deductions and marginal tax rates. As Tom Gibson recently explained to CNBC CPA:
“The goal of tax planning is to minimize the taxes that you pay not only this year, but over many years, and ideally, throughout your life. An experienced tax planner, such as the vice president of corporate tax planning, can lower the effective tax rate for individuals. ”
How to remember the difference between the two
If you find the mnemonic useful, think of the marginal tax as “MT”, which means “empty buckets” that you need to fill. Effective tax is the “ET” of “total tax,” which means the total tax rate for your total income.