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When you’re planning for taxes, it’s helpful to know both your marginal tax rate and your effective tax rate. Marginal tax rate is the percentage you pay in taxes on the last dollar you earn, while effective tax rate is the average tax rate you pay overall to the federal government.
The difference between the two may not seem important, but understanding how each one is calculated is vital to understanding our tax system — and your own bill.
What is a marginal tax rate?
Marginal tax rate is the percentage of federal income tax you pay on the final dollar of income for the tax year. There are currently seven marginal rates in the tax code, ranging from 10% to 37%.
The U.S. has a progressive tax system in which Americans with higher levels of income are expected to shoulder a greater share of the tax burden. Your tax liability is lower on the first portion of income you earn. But as you earn more money, the additional income is taxed at progressively higher rates. Essentially, your marginal tax rate is the highest tax bracket you fall into based on your taxable income.
Read more: 7 free tax filing options
Calculating your taxable income
To calculate your marginal tax rate, first, you need to calculate your taxable income.
Your taxable income consists of most sources of income (including salary, wages, tips, and commissions) minus certain deductions, like student loan interest and contributions to pre-tax retirement accounts or a health savings account (HSA). The result is your adjusted gross income.
From there, you’ll choose between the standard deduction vs. itemizing when you file your return during tax season. The 2023 standard deduction (for taxes due in 2024) ranges from $13,850 for single filers to $27,700 for married couples filing jointly.
You can subtract the full standard deduction for your filing expenses from your taxable income, regardless of your actual expenses. Or if you opt to itemize, you can deduct things like mortgage interest and charitable contributions, but you can’t take the standard deduction.
Once you’ve subtracted either the standard deduction or your itemized deductions, you’ll know your taxable income. You’ll use that number to figure out your marginal tax rate.
Read more: How to choose the right filing status
Example of how to determine your marginal tax bracket
Let’s assume your filing status is head of household, and you have taxable income of $55,000 in 2023. Your marginal tax rate is 12%, which you can easily see by checking the 2023 tax brackets chart below. That doesn’t mean your actual rate is 12% though. Your tax bill would break down as follows based on your taxable income and filing status:
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You’d owe 10% of the first $15,700 you earn, or $1,570.
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You’d owe 12% on the next $39,300 you earn ($55,000-$15,700), or $4,716.
Your total tax bill would be $6,286, which means your overall tax rate — also called effective tax rate — is 11.3%.
If your income jumped to $60,000, you’d find yourself in a higher tax bracket. Your marginal tax rate would climb to 22%. But the 22% tax rate would only apply to the amount of income that spilled over from the lower tax bracket of 12%.
All the income you earned between $15,701 and $59,850 is still taxed at 12%. Only the last $150 of income ($60,000-$59,850) gets taxed at the 22% rate. As a result, your tax liability breaks down like this:
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You’d owe 10% of the first $15,700 you earn, or $1,570.
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You’d owe 12% on the next $44,150 you earn ($59,850-$15,700), or $5,298.
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You’d owe 22% on the next $150 you earn ($60,000-$59,850), or $33.
Your marginal tax rate increased significantly, from 12% to 22%. But your overall tax rate (aka effective rate) increased modestly from 11.3% to 11.5% because most of your income is still taxed in a lower bracket. Your tax bill increased by about $600, to $6,901.
The following federal income tax rates will determine your tax liability for 2023 and apply when you file your tax return due on April 15, 2024.
A little more on effective tax rates
We covered effective tax rate in the example above, but here’s a straightforward definition. Effective tax rate is the average tax rate you pay on all of your income. Because effective tax rate is an average, while marginal tax rate is the highest rate you pay, your effective tax rate will be lower than your marginal tax rate.
Going back to the example of the head of household filer who earned $55,000, or $60,000 after a raise. The taxpayer’s marginal tax rate was 12%, or 22% after their income increased. Their effective tax rates before and after the pay hike were 11.3% and 11.5%, respectively.
You may also qualify for tax credits, which reduce your tax bill dollar for dollar. Depending on the type, some tax credits can even help you score a refund.
But your effective tax rate doesn’t paint the full picture of all the taxes you pay. That’s because it only shows the amount you pay in federal income taxes relative to your taxable income, but most people pay additional taxes.
For example, most W-2 employees pay 7.65% of their income toward Social Security and Medicare taxes. Self-employed people usually pay 15.3%, or double the amount traditionally employed people pay, because they’re responsible for both the employee and the employer’s share of these taxes. Also not included in the effective tax rate equation are state and local taxes, sales taxes, and property taxes.
How to calculate your effective tax rate
Calculating your effective tax rate is fairly straightforward. You’ll simply divide the amount you owe the Internal Revenue Service (IRS) in taxes by your taxable income for the year, then multiply the number by 100.
Let’s assume you’re a single filer with a taxable income of $75,000 in 2023. Your tax liability is $11,000. To calculate your effective tax rate, you’d follow these steps:
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Divide the amount you owe the IRS ($11,000) by your taxable income ($75,000). The result is 0.1466.
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Multiply the result (0.1466) by 100 to get your effective tax rate: 14.66%.
If you wanted to lower your effective tax rate in subsequent years, you could do so by funding a pre-tax 401(k), traditional IRA, or HSA. You could also look for additional tax credits and tax deductions.
Read more: All about the child tax credit, earned income tax credit, and dependent care credit.
The bottom line on marginal vs. effective tax rates
You may fear that if your marginal tax rate increases because you’re earning more income, you’ll bring home less money because of the extra taxes. But you don’t need to worry.
One of the biggest personal finance myths is that if you get bumped into a higher income tax bracket, all of your income will be taxed at a higher rate. The truth is, only income that exceeds the limit of the lower bracket is subject to the higher tax rate. Much of your income will still be taxed at lower rates. An increase in marginal tax rate often only increases effective tax rate by a minimal amount.
So don’t fret that extra income will put you in a higher tax bracket. Being in a higher tax bracket will still mean higher take-home pay for you.
FAQ
Why is marginal tax rate higher than effective tax rate?
Marginal tax rate is higher than effective tax rate because it represents the highest tax bracket you’re taxed at, whereas effective tax rate is an average. Marginal tax rate is the percentage you’re taxed on the last dollar of income. At lower income levels, a smaller portion of your income is taxed.
How can I lower my effective tax rate?
To lower your effective tax rate, consider making pre-tax contributions to tax-advantaged accounts, like a 401(k), individual retirement account (IRA), or HSA. Consult with a tax pro about whether you’ll pay lower taxes if you take the standard deduction or itemize deductions. Also, take advantage of any tax credits you may qualify for.
What are the different income tax rates?
The IRS income tax rates are 10%, 12%, 22%, 24%, 32%, 35%, and 37%. Lower levels of incomes are taxed at lower tax rates. As you earn more money, the taxes you pay on each additional dollar you earn gradually go up.