Question: What is the difference between marginal and effective tax rates, and which is more important?
Answer: To explain the difference between "marginal" and "effective" tax rates, I'll first dispel a common misconception: All of the income you make is not taxed at one rate. For example, let's say you are a single filer who makes $50,000 per year, which puts you in the 22% tax bracket. If you paid tax at a flat 22% rate on your income, you would owe $11,000. But if you look up $50,000 in the IRS' 2018 1040 Tax Tables, you'll find that you owe less than that--$6,945, to be exact. Why is that?
You pay taxes in tiers. Single filers are taxed at a 10% rate on the first $9,525 of income, which is the upper boundary of the 10% tax bracket. The next $29,175 of income--the amount from $9,525 to $38,700--is taxed at 12%. The next bracket, 22%, goes from $38,700 to $82,500. This is the final strata in our example because $50,000 in taxable income doesn't reach the upper boundary of the 22% bracket. Therefore, the upper 22% rate will apply only to taxable income that exceeds $38,700 (the upper limit of the 12% tax bracket).
In our example, that means only the last $11,300 in taxable income made during the year ($50,000 - $38,700) is subject to the 22% marginal tax rate. The effective tax rate, meanwhile, represents the average tax rate you pay on all the money you make during the year.
When Marginal Rates Matter
As a taxpayer the marginal tax rate--what you pay at the very top end of your taxable income--differs quite a bit from what you pay as an overall, average tax rate on your income. Why do we hear so much about marginal income tax rates when effective income tax rates are arguably more important?
There are a few reasons. For one, political debates over income taxes often center on marginal rates. Currently sparking controversy is the mooted 70% marginal tax rate on multimillion-dollar incomes by Rep. Alexandria Ocasio-Cortez, D-N.Y.
The more important reason that marginal rates matter, though, is they can factor into certain tax-management decisions. For example, let's say a taxpayer is considering whether to contribute to a traditional IRA, in which contributions are tax deductible, or a Roth IRA, in which contributions are not deductible but qualified withdrawals are tax-free (qualified withdrawals from a traditional IRA are taxed). Since a contribution to a traditional IRA lowers the investor's overall taxable income, the deduction is typically calculated based on the investor's marginal tax rate--that is, the rate paid on his or her last dollar of taxable income for the year. If the investor contributed $5,500 to a traditional IRA in 2018 and falls in the 22% marginal tax bracket, the deduction on the contribution can be said to be worth a tax savings of $1,210 ($5,500 x 0.22).
Conventional wisdom says if one expects his or her marginal rate to go down in retirement, the traditional deductible retirement account is preferable, while if he or she expects it to go up, the Roth is better. If the individual expects his or her marginal rate to remain the same in retirement, one could argue for either the traditional account or the Roth, as discussed in this article.
Figuring Out Your Marginal and Effective Tax Rates
Use this table to see find your marginal tax rate and figure out where your taxable income falls within the brackets.
To calculate your effective federal income tax rate, look at line 15 of your 1040 form to find your total tax. Divide this amount by your taxable income, found on line 10. Multiply the number by 100 to get your effective tax rate. (This method looks at your tax rate on income after deductions are applied; but if you wanted to use your income before these are taken out, you could instead use your adjusted gross income, found on line 7 of the 2018 form 1040.)
If you also pay state or local income tax, you can do a similar calculation using the relevant numbers.