Marginal tax rate vs. effective tax rate: What you need to know for better tax planning

Key takeaways

• The U.S. uses a progressive tax system, where income is divided into different brackets, each taxed at a different rate.
• The marginal tax rate is the percentage of tax applied to your last dollar of income.
• The effective tax rate is the average rate of tax applied to your total income.
• Understanding marginal and effective tax rates is important for many reasons, including financial planning, budgeting, strategic decision making, and more.
• Work with a Tax Pro to ensure you're making the most of your tax strategy and taking advantage of all available deductions and credits.

Marginal tax rate vs. effective tax rate: Key differences

Understanding marginal and effective tax rates, and the differences between the two, is crucial to ensure you’re getting every dollar you deserve and not paying a cent more than you have to when you file. Before we break down these important concepts, let's take a quick look at how tax brackets work.

The U.S. uses a progressive tax system, meaning your income is divided into different ranges, or brackets, each taxed at a different rate. For example, if you're a single filer in 2024, you could fall into tax brackets ranging from 10% to 37%. Only the portion of your income that falls within each bracket is taxed at that bracket's rate.

The marginal tax rate is the percentage of tax that’s applied to your last dollar of income. In other words, it shows the rate at which your next dollar of income will be taxed. To find your marginal tax rate, simply look at the tax bracket your highest dollar of income falls into.

The effective tax rate, on the other hand, is the average rate of tax applied to your total income. It gives you a sense of the average rate you pay across all your income, providing an overall picture of your tax.

Understanding both rates can help you make more informed decisions about your finances, from budgeting to investing, and ensure you're optimizing your tax strategy.

What is the marginal tax rate?

As we mentioned, the marginal tax rate is the percentage of tax you pay on your last dollar of income. In other words, it’s the highest tax bracket you fall into. Imagine you earn more money and move into a higher tax bracket. The new rate doesn’t apply to your entire income, just the income above the previous bracket's limit. Think of it as climbing a staircase, where each step represents a different tax rate.

How to calculate the marginal tax rate

To calculate your marginal tax rate, start by finding your total taxable income. Add up all your income sources like salary, investment income, gig work, and other earnings. Then, subtract any deductions you qualify for to get your taxable income.

Next, check the 2024 federal tax brackets, which are based on filing status and income, to see where you fall.

Finally, identify the highest tax rate that applies to any part of your income. This is your marginal tax rate.

Marginal tax rate example

Imagine Josie, a single filer with a taxable income of $50,000 in 2024. Here’s a breakdown of the tax rates she’ll owe on her income.

• 10% on the first $11,600, which equals $1,160
• 12% on the next $35,550, which equals $4,266
• 22% on the remaining $2,850, which equals $627

In this case, Josie’s marginal tax rate is 22%, because that’s the rate applied to her last dollar of income. Knowing your marginal tax rate is important for making decisions about bonuses, investments, and other additional earnings, because it helps you understand the rate at which it will be taxed.

What is the effective tax rate?

The effective tax rate gives you the average rate you pay on all your income. It provides a more accurate picture of your overall tax burden, because it considers the different rates applied to various portions of your income.

Think of it like a layered cake. The marginal tax rate is the frosting on the top layer, representing the highest rate applied to your last bit of income. In contrast, the effective tax rate is like the flavor of the entire cake, giving you an average taste of all the layers combined.

How to calculate the effective tax rate

To calculate your effective tax rate, first, determine the total amount of federal income tax for the year. You can find this on your tax return.

Next, find your total taxable income, which includes your salary, investment income, and any other earnings, minus any deductions you qualify for.

Finally, divide your total tax liability by your total taxable income, and then multiply by 100 to find your average effective tax rate.

Effective tax rate example

To see how this works in practice, let’s take another look at Josie, a single filer with a taxable income of $50,000 in 2024 and a total tax bill of $6,053. Here’s how to calculate her effective tax rate.

In this example, Josie’s effective tax rate is 12.1%. This means that, on average, 12.1% of Josie’s income goes toward paying federal income taxes.

The importance of understanding tax rates

Understanding marginal and effective tax rates is essential for several reasons:

Maximizing deductions and credits: Being aware of your tax rates can also help you maximize deductions and credits. For example, if you know your marginal tax rate, you can better understand the potential tax savings from deductions or retirement plan contributions.

Budgeting: Your effective tax rate provides a clearer picture of your overall tax burden. This can be particularly helpful for budgeting and financial planning. By knowing your effective tax rate, you can better estimate how much of your income will go toward taxes and how much you'll have left for other expenses.

Strategic decisions: Whether you're thinking about selling investments, making charitable donations, or planning for retirement, understanding your tax rates can guide your decisions. Knowing how different actions will affect your taxable income and overall tax burden allows you to plan more strategically.

Financial planning: Understanding your marginal tax rate helps you make informed decisions about earning additional income. For instance, if you're considering doing extra work or making an investment that will yield more income, it can help you estimate how much of that extra income you'll keep after taxes.

Seeking professional tax advice

Learning the nuances of marginal and effective tax rates can help with financial and tax planning. However, taxes can be complex, and everyone's situation is unique. To ensure you're making the most of your tax strategy, consider seeking professional tax advice.

A Jackson Hewitt Tax Pro can provide personalized guidance and ensure you're taking advantage of all available deductions and credits. Best of all, we’re open all year.

You don’t have to wait until tax season to start planning. Start taking steps toward getting every dollar you deserve by booking your appointment today!

About the Author

Mark Steber is Senior Vice President and Chief Tax Information Officer for Jackson Hewitt. With over 30 years of experience, he oversees tax service delivery, quality assurance and tax law adherence. Mark is Jackson Hewitt’s national spokesperson and liaison to the Internal Revenue Service and other government authorities. He is a Certified Public Accountant (CPA), holds registrations in Alabama and Georgia, and is an expert on consumer income taxes including electronic tax and tax data protection.

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