Supreme Court Justice Oliver Wendell Holmes, Jr. once famously wrote, "Taxes are the price we pay for a civilized society." And while that's certainly true, it doesn't mean anyone should pay a penny more than they are required to.
Our current complex tax code offers hundreds of ways to reduce what you owe, and because of its progressive design, your tax rate rises along with your income. It can get downright confusing, especially when it comes to understanding the difference between your marginal tax bracket and your effective tax rate.
Here's what you need to know and why it's important to understand the difference.
Image source: Getty Images.
Marginal tax brackets explained
So what exactly is a marginal tax bracket? It's the tax rate you'll pay on the portion of your taxable income that exceeds a certain threshold. It's also what people refer to as their "tax bracket." Your marginal tax rate depends on your filing status and taxable income.
Here are the tax brackets by filing status and income for 2016:
| Marginal Tax Rate | Taxable Income | ||
|---|---|---|---|
| Single Filer | Married Filing Jointly | Head of Household | |
| 10% | $0 to $9,275 | $0 to $18,550 | $0 to $13,250 |
| 15% | $9,275 to $37,650 | $18,550 to $75,300 | $13,250 to $50,400 |
| 25% | $37,650 to $91,150 | $75,300 to $151,900 | $50,400 to $130,150 |
| 28% | $91,150 to $190,150 | $151,900 to $231,450 | $130,150 to $210,800 |
| 33% | $190,150 to $413,350 | $231,450 to $413,350 | $210,800 to $413,350 |
| 35% | $413,350 to $415,050 | $413,350 to $466,950 | $413,350 to $441,000 |
| 39.6% | $415,050+ | $466,950+ | $441,000+ |
Data source: IRS.
Many people think their income tax is their marginal tax rate multiplied by their taxable income. For example, a single filer with taxable income of $60,000 might assume they owe $15,000 in income tax because they are in the 25% tax bracket. However, that's simply not true. Most of your income will likely be taxed at a lower rate than your marginal tax rate.
The tables below can help you figure out how much income tax you actually owe based on your filing status and your taxable income.
Single filing status:
| If your income is over... | ...but not over... | ...then your tax is... | ...plus this percentage... | ...of the amount over this threshold. |
|---|---|---|---|---|
| $0 | $9,275 | NA | 10% | $0 |
| $9,275 | $37,650 | $927.50 | 15% | $9,275 |
| $37,650 | $91,150 | $5,183.75 | 25% | $37,650 |
| $91,150 | $190,150 | $18,558.75 | 28% | $91,150 |
| $190,150 | $413,350 | $46,278.75 | 33% | $190,150 |
| $413,350 | $415,050 | $119,934.75 | 35% | $413,350 |
| $415,050 | NA | $120,529.75 | 39.6% | $415,050 |
Table by author: Data source: IRS.
Head of household:
| If your income is over... | ...but not over... | ...then your tax is... | ...plus this percentage... | ...of the amount over this threshold. |
|---|---|---|---|---|
| $0 | $13,250 | $0 | 10% | $0 |
| $13,250 | $50,400 | $1,325 | 15% | $13,250 |
| $50,400 | $130,150 | $6,897.50 | 25% | $50,400 |
| $130,150 | $210,800 | $26,835.00 | 28% | $130,150 |
| $210,800 | $413,350 | $49,417.00 | 33% | $210,800 |
| $413,350 | $441,000 | $116,258.50 | 35% | $413,350 |
| $441,000 | NA | $125,936.00 | 39.6% | $441,000 |
Table by author. Data source: IRS.
Married filing jointly or qualifying widow(er):
| If your income is over... | ...but not over... | ...then your tax is... | ...plus this percentage... | ...of the amount over this threshold. |
|---|---|---|---|---|
| $0 | $18,550 | $0 | 10% | $0 |
| $18,550 | $75,300 | $1,855 | 15% | $18,550 |
| $75,300 | $151,900 | $10,367.50 | 25% | $75,300 |
| $151,900 | $231,450 | $29,517.50 | 28% | $151,900 |
| $231,450 | $413,350 | $51,791.50 | 33% | $231,450 |
| $413,350 | $466,950 | $111,818.50 | 35% | $413,350 |
| $466,950 | NA | $130,578.50 | 39.6% | $466,950 |
Table by author. Data source: IRS.
Married filing separately:
| If your income is over... | ...but not over... | ...then your tax is... | ...plus this percentage... | ...of the amount over this threshold. |
|---|---|---|---|---|
| $0 | $9,275 | $0 | 10% | $0 |
| $9,275 | $37,650 | $927.50 | 15% | $9,275 |
| $37,650 | $75,950 | $5,183.75 | 25% | $37,650 |
| $75,950 | $115,725 | $14,758.75 | 28% | $75,950 |
| $115,725 | $206,675 | $25,895.75 | 33% | $115,725 |
| $206,675 | $233,475 | $55,909.25 | 35% | $206,675 |
| $233,475 | NA | $65,289.25 | 39.6% | $233,475 |
Table by author. Data source: IRS.
As an example, let's use our hypothetical single taxpayer who has $60,000 in taxable income. The first $9,275 in income is taxed at 10%, the next $28,375 (that's $37,650 minus $9,275) is taxed at 15%, and the remaining $22,350 (that's $60,000 minus $37,650) is taxed at 25%. Add it all together, and this taxpayer owes a total of $10,771.25 in income tax -- just 18% of their income. In other words, 18% is their effective tax rate.
Deductions are important to determining your effective tax rate
But before you can figure out how much income tax you'll owe, you'll need to determine how much you can lower your tax bill with any deductions and credits you can claim. Many taxpayers with simple financial situations just take the standard deduction and call it a day, but others qualify for a number of deductions and credits -- some of them highly valuable. (Note: tax deductions reduce your taxable income, while tax credits are subtracted directly from your tax bill.)
Here are some common deductions and credits:
Deductions
- Mortgage interest (requires taxpayer to itemize deductions)
- Property tax (taxpayer must itemize)
- Charitable contributions (taxpayer must itemize)
- Employee contributions to retirement accounts such as 401(k)s
Credits
- Saver's Credit
- Child and Dependent Care Credit
- Earned Income Tax Credit
- American Opportunity Credit
A simple example of how you determine your effective tax rate
Let's use the median U.S. household income, which is around $54,000, as an example. If you're a married joint filer earning that amount, that's your gross income, not your taxable income. So you'll need to figure out your deductions to get to your taxable income. Using the example above, the standard deduction in 2016 will be $12,600. If we subtract that standard deduction from $54,000, we get $41,400.
A married joint filer earning $41,400 in taxable income would fall in the 15% marginal tax bracket but would only pay 15% on income over $18,550 while paying 10% on the first $18,550 in taxable income. So here's how you would calculate your effective tax rate:
- $18,550 x 10% tax rate = $1,855 in tax
- $41,400 - $18,550 = $22,850 taxed at 15%
- $22,850 x 15% tax rate = $3,427.50 in tax
- $1,855 + $3,427.50 = $5,282.50 in total income tax
- $5,282.50 / $54,000 = 9.8% effective tax rate
So the effective tax rate would be 9.8% for our theoretical median American taxpayer. If they had more tax deductions or credits, then their effective tax rate could be even lower.
Why it matters
At the end of the day, your effective tax rate is what matters most because that's the actual percentage of your hard-earned total income that you surrender to the government. If you make sure to take advantage of every potential tax credit and deduction you're eligible for, your effective tax rate can be substantially lower than your marginal tax bracket.
