It is no secret that the IRA tax code can be confusing. Filers sometimes misinterpret rates and end up believing they must pay more than they usually do. Understanding marginal and effective tax rates are important for tax planning purposes.
A funny anecdote is the story of Former Secretary of Defense Donald Rumsfeld. Every year when he would file his taxes, he includes a letter to the IRS indicating that our tax law was overly complex. Here’s an excerpt from one of his letters:
“Once again, I have mailed in our federal income tax and gift tax filings for 2015, and have requested an extension due to the delays in materials required to complete our tax return. Despite having performed this civic duty for over half a century, at the concluding of filing this year’s taxes, I remain mystified as to whether or not our tax returns and tax payment estimates are accurate. The possession of a college degree, retention of an experienced tax accounting firm, and earnest application have failed to provide confidence that my returns and payments are properly completed.”
Funny, right? There is some truth to this…thus I think it’s important to outline, at the very least, the difference between marginal and effective tax rates.
Marginal Tax Rate
The United States has a progressive tax system, which places a higher tax burden on people who earn more. So, the more money you earn, the higher your tax rate is, and the more taxes you pay to the IRS.
In 2021, there are seven tax brackets ranging from 10% to 37%. This table indicates the current rates for 2021:
Once you know your total taxable income, it’s fairly easy to see which marginal tax rate you have.
If you earn $35,000 a year as a single filer, you are in the 12% tax bracket. If you make $520,000 a year as a single filer, you are in the 37% tax bracket. These brackets represent the percentage of taxes you pay based on your taxable income and are referred to as marginal tax rates.
So when someone says they are “in the 35% tax bracket”, this is typically what they are referring to. Also, this is where the confusion begins.
For many taxpayers, their income is the same as their earnings from wages; however, taxpayers should note that income from capital gains may be taxed differently. Short-term capital gains are generally taxed as ordinary income subject to the seven tax brackets mentioned above. Long-term capital gains, however, are taxed at 0%, 15%, and 20%.
Due to the way the tax code is set up and because marginal tax rates apply to each additional level of income above your tax bracket’s income limit, it is not as straightforward as it seems. If you are single and earn $100,000 – in the 24% tax bracket – it doesn’t mean that you pay a 24% tax on your earned income (0.24 x $100,000 = $24,000).
To illustrate how this works, let’s look at the following example for a single taxpayer earning $100,000 of annual income in 2021 (i.e., filing a tax return in April 2022). The amount of tax owed breaks down as follows:
- 10% Bracket: ($9,950 – $0) x 10% = $995.50
- 12% Bracket: ($40,525 – $9,950) x 12% = $3,669.00
- 22% Bracket: ($86,375 – $40,525) x 22% = $10,087.00
- 24% Bracket: ($100,000 – $86,375) x 24% = $3,270.00
Total tax = $18,021.50
So, you go bracket by bracket, paying the percentage on the amount of income that falls within that bracket. All the way until you’ve reached the bracket matching your total income.
Effective Tax Rate
So what’s with the effective tax rate? Well, once you know your income and your total federal income tax liability, then it’s easy to figure out your effective rate.
The effective tax rate is the actual amount of federal income taxes paid on a taxpayer’s taxable income and more accurately represents the amount of tax most people pay. The effective tax rate does not include state taxes and local taxes, FICA taxes, or self-employment tax.
In the example above, the effective tax rate is close to 18% ($18,021.50/$100,000) – without taking any deduction that reduces taxable income. This is lower than this taxpayer’s marginal tax rate of 24%.
Many taxpayers take advantage of tax credits and deductions that reduce taxable income, such as the standard deduction, tax-deductible contributions to a retirement or pension plan, health savings account, tax credits for dependent children, and charitable contributions.
In general, calculating your effective tax rate is relatively simple: Divide your total tax liability by your gross (before tax) annual income.
Here’s an example: if you made $100,000 (single filer), took the standard deduction of $12,500 in 2021, reducing your income to $87,450, and paid $15,009.50 in tax, the effective tax rate is 15 percent even though you are in the “24%” tax bracket.
Financial planners like myself typically look at marginal tax rates when evaluating client scenarios. For example, deciding whether or not to defer or accelerate income in a given year, or to perform Roth conversions. In other words, we might make changes to our strategy based on the marginal rate.
The effective rate is really used to compare one person’s tax obligation to another person. Good examples include these recent political debates with Trump, Romney, Peter Theil, Bernie Sanders, etc.
One notable story was about one of the wealthiest men on the planet, Warren Buffet. Remember when people were up in arms saying that Buffet’s effective tax rate was less than his secretary’s? The total amount of taxes that he actually pays is still far larger (in the millions!) than his secretary (in the thousands). So “effective tax rate” is really just the portion of the individual’s overall income that is consumed by taxes.
If you feel like too much of your hard-earned money goes straight to the IRS instead of your bank account, give us a shout. We all must pay taxes, but let’s make sure you don’t have to pay more than you are obligated to. We might even have some tax planning strategies that could save you money.