Taxes are an integral part of financial planning. Understanding your marginal and effective tax rates, and how they are calculated, can help you make better money decisions. Marginal Rate – The number one thing most people know about their taxes (other than that they’re too high) is their tax bracket. The U.S. has a progressive income tax system, meaning that the more money you make, the higher the tax rate.
For the 2016 tax year, the highest tax bracket is 39.6% for single filers making $415,050 or more, and for married filers making $466,950 or more. This rate is referred to as the marginal rate, and means that any additional dollar the individual or family makes over this amount is taxed at 39.6%. The marginal rate, however, does not mean that a family making $500,000 turns over 39.6% to the IRS.
Rather, if a family ends up with a taxable income of $500,000, only the amount in excess of $466,950 would be taxed at 39.6%. The rest is taxed on the lower rate hierarchy. Perhaps most importantly, the tax code has a variety of exemptions, credits and deductions built in.
Think about tax breaks for children, mortgage interest, student loan interest and retirement savings. Almost everyone benefits from these breaks. So in essence, a gross income of $500,000 can easily turn into a taxable income of $350,000, and a middle-class income of $50,000 can turn into a taxable income of zero.
Effective Rate – Your effective tax rate is the amount that actually goes to the IRS after all the exemptions, credits and deductions are applied, and after your income is taxed on the lower rate hierarchy.
As an example, say your family makes $100,000 in income for 2016. Your marginal rate would be 25%. But after taking your tax breaks, your taxable income may fall to some number close to $60,000, putting you at a 15% marginal rate. Then run this number through the lower rate hierarchy mill, and the actual amount of your income that you pay to the IRS could hover around 8.4% – your effective tax rate.