Q. What's the difference between a "marginal tax rate" and an "effective tax rate"?
A. Your marginal tax rate is the rate at which your last and your next dollar of taxable income are taxed. It's not the rate at which all your dollars are taxed. It's the maximum rate you're paying on any of your dollars of taxable income. For example, according to the rules at the time of this writing, the marginal tax rates for single filers are 15%, 27.5%, 30.5%, 35.5%, and 39.1%.
Remember that your marginal tax rate only deals with the specific tax on your income. There are other taxes that you may have to pay -- such as Social Security taxes, self-employment taxes, alternative minimum taxes, and even penalty taxes on retirement plan distributions. There are also credits that you may benefit from, such as the child tax credit, the dependent care credit, or education credits.
So, after considering the jumble of other taxes and credits, your marginal tax rate may lose a bit of its relevance. Which is why you'll want to take a peek at your effective tax rate. Your effective tax rate reveals the average rate of taxation for all your dollars. It's your total tax obligation (including your income tax and any other additional taxes and/or credits), divided by your total taxable income.
After all is said and done, it is very likely that your effective tax rate will be higher or lower than your marginal rate.
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This question and answer is adapted from The Motley Fool Money Guide: Answers to Your Questions About Saving, Spending and Investing. For answers to this and 499 other common money questions, check it out -- it's a handy resource (and a terrific holiday gift!).
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Reader Response to a Previous Q&A
What About "Impure" Plays?
On our Drip Investing Basics discussion board, A. Brunelle comments on a column about "pure-play" companies:
[Selena] makes the point that "When investors are drawn to a particular kind of business, they may seek out a company that's a pure play so their invested dollars won't be spread out over other, less desirable business segments."
On the other hand, she doesn't make the counterpoint that other investors may be attracted to the concept of a well-run diversified company over a company that is susceptible to hits taken to a specific product/segment. From my own experience, I seem to be drawn toward the latter types of companies. I own Johnson & Johnson, Pfizer, and Intel -- the last is certainly more than "just a CPU" company, although it is primarily in the semiconductor arena. And I'm currently looking at adding either Pepsi or General Electric -- both of which are rather "impure."
As I only Drip into a small number of companies (I'm probably going to max out at five, and wouldn't be surprised if I decided on both Pepsi and GE to fill it out!), it makes some sense (to me at least) to select companies that have some diversity built into them.
Just curious: How much does a company's "pureness" impact your decisions on what companies to Drip into?
[Editor's note: "Drips" are direct investment or dividend reinvestment plans, which permit you to invest small amounts of money directly in companies, bypassing brokers. If that sounds good to you, pull up a desk in the Fool's School Drip classroom.]
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