Now that it’s officially fall, I know that any morning I might step outside and feel that telltale chill in the air.
As a result, if I haven’t checked my favorite weather app — maybe I’m too busy or just dreading the cold start — I might dress for my day assuming the coldest.
However, by noon, the sun’s come out, it’s very warm, and I’m sweating — wishing I had taken the time to prepare.
It’s the same mindset required when it comes to knowing your tax rate .
You ask someone what they pay in taxes, and the answer is often something ranging from “None of your business” to “I don’t know … one of the top brackets.”
While technically this might be true, it’s also incomplete. One of the most common misconceptions in tax planning is confusing your tax bracket with the actual rate of tax you pay.
Understanding the difference between your marginal tax rate, your effective tax rate and what contributes to the difference can help you make better financial decisions, evaluate planning opportunities more accurately and avoid unnecessary anxiety about moving into a higher tax bracket.
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The author of this article is a participant in Kiplinger’s Adviser Intel program, a curated network of trusted financial professionals who share expert insights on wealth building and preservation. Contributors, including fiduciary financial planners, wealth managers, CEOs and attorneys, provide actionable advice about retirement planning, estate planning, tax strategies and more. Experts are invited to contribute and do not pay to be included, so you can trust their advice is honest and valuable.
Your bracket is not your bill
The United States uses a progressive income tax system .
Rather than taxing all your income at a single rate, your income is divided into layers, with each taxed at a different rate. Your marginal tax rate is the rate applied to your last, or highest, dollar of taxable income. It tells you how much tax you’ll pay on the next dollar you earn.
Many taxpayers mistakenly believe that once their income crosses into a higher bracket, all that income is taxed at a higher rate. Fortunately, that’s not how the system works. Think of it like a staircase. As your income rises, each step is taxed at a different rate. You don’t retax the lower steps at the highest rate.
How it works
Suppose the taxpayer has $200,000 of taxable income, and she falls into a 24% marginal tax bracket.
A common misunderstanding is that she pays 24% tax on the entire $200,000, resulting in a tax bill of $48,000.
But really, her tax calculation works progressively.
The first portion of taxable income is taxed at 10%, the next portion at 12%, the next at 22%, and only the portion that reaches the 24% bracket is taxed at 24%.
Let’s take out any variables of deductions or credits and assume her total federal income tax liability is $31,000. Her effective tax rate would be 15.5% ($31,000 divided by $200,000 equals 15.5%). In other words, while our friend is in the 24% tax bracket, her average federal tax rate is only 15.5%.
This distinction is critical, because both numbers serve different purposes.
I recognize all this requires a little bit of math … a daunting prospect for any of us. It’s a great reminder that creating a solid, personal plan with a financial adviser , accountant or an attorney is critical to making smart financial decisions about your own situation.
Why your effective tax rate matters
Your effective tax rate represents the average rate of tax paid across your taxable income and is generally a better indicator of your overall tax burden than your marginal rate.
To better illustrate that point, let’s walk through how two taxpayers could both earn $200,000, but have significantly different effective tax rates — one taxpayer who receives most of his income from wages, while another receives a substantial amount from qualified dividends and long-term capital gains.
Since investment income might qualify for preferential tax treatment, Taxpayer No. 2 could have a much lower effective tax rate.
Another impact is the number and amount of deductions and credits that each taxpayer has — such as charitable contributions, mortgage interest, state and local tax deductions or child and education credits.
The result is two taxpayers with similar incomes who experience very different tax outcomes.
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Which tax rate?
The answer depends on the decision you make.
Your marginal tax rate is often the more useful number when tax planning.
For example:
Should you convert funds from a traditional IRA to a Roth IRA ?
Should you make an additional charitable contribution this year?
Does tax-loss harvesting make sense?
What could a bonus or additional income from consulting cost you?
In each situation, the relevant question is how much tax applies to the next dollar of income — and that is your marginal rate.
Your effective tax rate , on the other hand, is often more useful for budgeting and overall financial planning. It provides a clearer picture of what percentage of your income is being paid in tax and how much remains available for spending, saving, investing or giving.
The bottom line
These are all valuable numbers, but they answer different questions.
If you’ve never calculated your effective tax rate, take a few minutes to review last year’s tax return . You might discover that your actual tax burden is considerably lower than your headline tax bracket suggests. That understanding can lead to smarter decisions about earning, investing, saving and planning for the future.
Now, when I’m leaving the house every morning, I’m thinking a little differently about my attire, planning for the immediate need of the cool morning and the warmth of later in the day.
Thinking about football games, pumpkin drinks and my tax rates!
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This article is for general information only and is not intended as an offer or solicitation for the sale of any financial product, service or other professional advice. Wilmington Trust does not provide tax, legal or accounting advice. Professional advice always requires consideration of individual circumstances.
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