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Taxes 101

The Difference between Marginal and Effective Tax Rate

Do you know the difference between marginal and effective tax rates? This was a topic that didn’t get a lot of attention until 2007, when billionaire Warren Buffett expressed his frustration with the fact that he pays a lower tax rate than his secretary. Buffett learned this after he conducted a survey of his employees and discovered they were paying an average of 32.9% — compared to his rate of 17.7%.

You might wonder, how is this possible? Don’t people who earn more money have to pay more in taxes?

The answer is, it depends. By design, your taxes should increase as your wages go up. However, it is also possible to pay a lower tax rate than someone else who earns much less than you do. In this post, we’ll talk more about the differences between marginal and effective tax rates — and what this means for your personal bottom line.

What Is a Marginal Tax Rate?

Our federal tax grid is divided into seven brackets ranging from 10% to 37%. The higher your taxable income, the higher the tax bracket you’ll belong to. However, this is not exactly how your taxes will be calculated.

Here is how SYM financial planner Scott Soptick explains it.

“Most everyone believes that all of their income will be taxed at whatever tax bracket they fall into. However, federal tax brackets work in a progressive manner. A certain portion of your income will start off in the lowest tax bracket and be taxed at the lowest rates. As you earn more, extra income will spill into the next bracket and be taxed at a higher rate, and so on.”

In other words, you could think of your marginal tax rate as the percentage charged on your last dollar of taxable income.

Here’s an example of how marginal taxes are calculated. Suppose you’re a single filer who earns a gross annual salary of $65,000. After a standard deduction of $12,550, your taxable income would be $52,450.

  • For the first $9,950 of your income, the marginal tax rate would be 10% or $995.
  • For the next $30,575 of your income, the marginal tax rate would be 12% or $3,669.
  • For the last remaining $11,925 of your income, the marginal tax rate would be 22% or $2,862.

Thus, your top marginal tax rate would be 22%, and your total taxes due would be $7,526.

For a complete list of the tax brackets and their corresponding income limits, you can check out this guide here. You should note that income limits depend on your tax filing status (single, married filing jointly, etc.)

What Is an Effective Tax Rate?

Your effective tax rate is the percentage of taxes you owe relative to your taxable income.

Your effective tax rate is determined by dividing your total amount of taxes by your taxable income for the year. Using the previous example of the single filer earning $65,000 per year and paying $7,526 in taxes, this individual’s effective tax rate would be:

$7,526 / $52,450 = 14.3%

As you can see from this calculation, this is probably much less than you would have expected. As Soptick points out, “We have clients that are in the 32% marginal tax bracket, which can look scary. However, when they calculate their effective tax rate, they’re pleasantly surprised to find out that their effective tax rate is much lower.”

How Can Higher Earning People Pay a Lower Effective Tax Rate?

Going back to the opening example with Warren Buffett and his secretary, why is it that he pays taxes at such a low effective rate?

Although every tax situation is unique, there are some factors that can influence how much you’ll owe to the IRS. Here are some of the most common ones.

  • Deductions are subtracted from your AGI (adjusted gross income) to reduce your taxable income. Although most people take the standard deduction, some filers can benefit from itemizing their deductions to take advantage of things like charitable donations, mortgage interest, etc.
  • Credits are a direct dollar-for-dollar reduction of your tax bill. The more credits you qualify for, the less you’ll have to pay in taxes. Some of the credits include child care credit, a credit for having an energy-efficient home, or a credit for buying an energy efficient car.
  • Long-term capital gains and qualified dividends. If you sell stocks or receive dividend payments for shares that were held for one year or more, that income will be taxed according to an entirely different tax bracket system. Whereas there are seven brackets for ordinary income, long-term capital gains and qualified dividends have only three brackets: 0%, 15%, and 20%. Under this system, someone who is earning a significant portion of their income from capital gains or dividends could pay much less than a standard taxpayer, even if their taxable income is higher.
  • Business expenses. Whether you own a business or earn money on the side (from activities such as side hustles), business expenses can be used to reduce how much tax you’ll have to pay. For instance, someone with rental properties could write off the mortgage interest, maintenance, insurance, utilities, etc. to offset the taxable revenue. For a great list of other commonly used tax-deductible business expenses, click here.

The Difference Between Marginal and Effective Tax Rate

You make dozens of decisions every single day, and many of those decisions have tax consequences. This is why two of the best professionals you can have on your team are a CPA and a financial advisor.

Although many financial advisors have extensive knowledge of taxes, a CPA may be more up to date on every nuance of the tax code. A financial advisor is valuable to guiding strategies because they have a holistic view of your financial picture and goals, while a CPA will get into the details specific to your taxes. As Soptick explains, “Sometimes taxes require specific research and specialized software. Financial advisors want to be part of tax planning, but we also don’t want to answer questions that go outside our expertise. This is where collaboration with a CPA can be tremendously valuable.”

If you are wondering what you can do to lower your tax bills, now and in the future, start with a plan and a strategy. SYM Financial advisors have helped many families navigate important decisions. We can work alongside your CPA to help eliminate surprises and aim to keep more money in your pocket. Reach out to a member of our team today.

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