Marginal vs. Effective Tax Rate
Under what authority?
The power to tax was granted to Congress through the Taxing and Spending Clause of the U.S. Constitution. This authority was further solidified by the 16th Amendment, which specifically permitted Congress to impose taxes on income. Congress passes tax law that becomes codified in the Internal Revenue Code (IRC) and the Internal Revenue Service (IRS), enforces it.
The IRC is extensive, spanning over 2,000 pages, with additional footnotes. In addition to the code itself, the IRS releases bulletins, ranging from 10 to 50 pages, detailing various aspects of the tax code. Fortunately, you don’t need to read all 2,000 + pages to grasp the basics. Familiarizing yourself with one of the most important concepts of the IRC can provide a solid foundation.
Note: This piece covers the taxation of ordinary income, not capital gains.
The Progressive Nature of Income Taxes
First, the basics: The Federal income tax is based on a progressive tax system. A progressive tax system is one where your tax rate increases as your income increases.
Federal Income Tax Brackets
Your federal income tax bracket is determined by two factors: your total income and your tax-filing status. In the 2024 tax year, there are seven tax brackets with corresponding rates for ordinary income, and their rates range from 10% to 37%.
The chart below shows the Marginal Tax Brackets for a couple filing as Married Filing Jointly (MFJ).
Not filing as MFJ? Here is the link to find the tax table for your filing status.
What's the Difference Between Marginal and Effective Tax Rate?
Marginal Tax Rate: The marginal tax rate is the tax rate applied to the last dollar of your taxable income.
Each tax bracket has a tax rate (percentage) that is applied to the dollars that fall within that bracket. When your income increases, and you enter a new bracket (range) you don't pay the higher rate on all of your income but only on the income that falls into the new bracket.
Example: Using the same filing status, MFJ, here is another way of looking at how marginal tax brackets work and the different tax rates are applied to your income.
Let’s look at a hypothetical example:
- A married couple filing Married Filing Jointly (MFJ)
- Gross income: $250,0000
- As you can see below only the income over the bottom range of the 24% bracket, is taxed at 24%:
- $250,000 - $201,051 = $48,949
- Of the total income of $250,000 only $48,949 will be taxed at their marginal tax rate of 24%.
Effective Tax Rate: The effective tax rate represents the percentage of a person’s taxable income that he or she pays in taxes.
As illustrated above, income is taxed at different and increasing rates as a person’s income grows and is assessed. To determine the true percentage of one’s income that one pays in taxes, you need to calculate their effective tax rate using the following formula:
We can use the formula to calculate the effective tax rate of the couple from our previous example.
- A married couple filing Married Filing Jointly (MFJ)
- Gross income: $250,0000
- Tax Liability: $46,084.54
As you can see, their marginal tax rate is 24%, but their effective tax rate--the more accurate measurement--is 18.43%.
This is important to understand because most people think they are taxed based on the highest tax bracket applicable to their income, but that is not the case. The important point here is not every dollar you make is taxed at your top marginal tax bracket. This provides an opportunity for tax planning. You can use this information to “fill up” tax brackets for Roth conversions and maximize the bracket you are in. Or you can use this information to strategically withdraw from certain accounts to minimize the tax consequences of withdrawals.
At Pacific Wealth Management, we work with our clients and their CPAs to be as tax efficient as possible with the goal of mitigating tax liability. To discuss tax planning strategies and your other financial priorities, contact us at contactus@pacwealth.com.