The Difference Between Marginal And Effective Tax Rates

There are a lot of misconceptions when it comes to personal income taxes, and one of the most misunderstood income tax concepts is the difference between the marginal tax rate and the effective tax rate.  Knowing the difference between marginal and effective rates is crucial to making smart tax decisions.The Difference Between Marginal and Effective Tax Rates


One reason why these two concepts are often misunderstood is because of the concept of tax brackets.  The U.S. has a progressive income tax, which means basically that the more money you make, the more money you will have to pay in taxes. There is a bracket system in place to make our income tax progressive.

For Example: For someone filing taxes as a single person in 2014, their first $9,075 of income is taxed at 10%.  Earnings over $9,075 up to $36,900 are taxed at 15%, and so on. The bracket system often leads to people saying “I’m in the X percent tax bracket.”

For Example: If Lindsay files as a single person in 2014 and earns a salary of $50,000, she might tell her friends that she’s “in the 25% tax bracket.” But this does not mean that all of Lindsay’s income is going to be taxed at 25%.  It just means that her marginal tax rate is 25%.


What is a Marginal Tax Rate?

• The marginal tax rate is the amount of tax paid on an additional dollar of income.

What this means for Lindsay is that any income in addition to her base $50,000 salary will be taxed at 25% (up to $89,350).  So if Lindsay gets a raise to $56,000, that extra $6,000 will be taxed at 25% and Lindsay will get $4,500 in after-tax money from her $6,000 raise.

Now let’s look at how Lindsay’s $56,000 income is taxed if she files as a single person in 2014.  This will allow us to determine her effective tax rate.

1. Lindsay’s first $9,075 of income is taxed at 10%, for a tax liability of $907.50.

2. Lindsay’s income over $9,075 and up to $36,900, is taxed at 15%.  This bracket of income leaves a tax liability of $4,173.75.

3. Lindsay’s income above $36,900, up to $89,350, is taxed at 25%.  This leaves $19,100 ($56,000 – $36,900) of income that will be taxed at 25%.  This bracket’s tax liability is $4,775.4.

To find Lindsay’s total tax we add the $907.50 in taxes from step 1, the $4,173.75 from step 2, and the $4,775 from step 3. This gives Lindsay a total tax liability of $9,856.25.

What is an Effective Tax Rate?

• The effective tax rate is the amount of tax owed divided by the taxable income.

Lindsay owes $9,856.25 in taxes on her income of $56,000.

Taxes owed ($9,856.2) divided by taxable income ($56,000) is 17.6%, so Lindsay’s effective tax rate is 17.6%.

What’s the Difference Between Marginal & Effective Tax Rates?

• The effective tax rate is the percentage of your taxable income that you effectively pay in taxes.

• The marginal tax rate is the percentage of tax that you will pay on your next dollar of taxable income.


Knowing the difference between these two concepts is crucial for making good tax decisions. A lot of people think their effective tax rate is higher than it actually is because they focus on their marginal rate when they say things like “I’m in the 25% tax bracket.”

Some people might take that statement to mean all of that person’s income is taxed at 25%, when in reality, that person’s effective tax rate will probably be significantly lower than 25%, just like Lindsay’s effective tax rate was in our example.

The difference between marginal and effective tax rates confuses a lot of tax payers.  We hope this article helps you better understand the difference between marginal and effective tax rates.


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