- Many taxpayers are confused about the difference between effective and marginal tax rates.
- The marginal tax rate is the rate of tax charged on a taxpayer's last dollar of income. The effective tax rate is the actual percentage of taxes you pay on all your taxable income.
- There are three major causes of differences between marginal and effective tax rates. Tax planning minimizes the taxes you pay not just this year but over a lifetime.
What is your marginal tax rate? What is your effective rate?
A point of confusion for many taxpayers is the difference between the two. Both measures tell a lot about a taxpayer's financial profile and both are used for tax-planning purposes to weigh the after-tax consequences of investments and transactions.
"If you're a ways into the top tax bracket, you need to use the marginal tax rate for planning," said Ryan Losi, a CPA with Piascik. "For 95% of Americans, however, the effective tax rate is the better tool for measurement."
The marginal tax rate is the rate of tax charged on a taxpayer's last dollar of income. It also determines the value of a specific deduction for a taxpayer. For example, a dollar of deductions for a person in the highest tax bracket of 37% is worth 37 cents in saved taxes. The same dollar of deductions for someone whose marginal tax rate is 24% would result in 24 cents of tax-saving benefit.
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The effective tax rate, on the other hand, is the actual percentage of taxes you pay on all your taxable income. It is the taxes paid divided by your taxable income. If the U.S. tax system were based on a flat tax, the marginal and effective tax rates would be the same, assuming no deductions and credits were allowed and taxpayers were in perfect compliance with the law. It, of course, is not.
The objective of tax planning is to minimize the taxes you pay not just this year but over many years and, ideally, over the course of your life. "The savvy tax planner, like a corporate VP of Tax Planning, can reduce an individual's effective tax rate," said Losi.
There are three major causes of differences between marginal and effective tax rates. The first is the progressive nature of the U.S. tax system. In 2020, there were seven tax brackets, ranging from 10% on the first $9,875 of income to 37% on income over $518,400. A taxpayer with taxable income of $520,000, therefore, pays a 37% tax on only $1,600. His or her marginal tax rate may be 37%, but his or her effective tax rate would be significantly lower.
The second is the nature of the income in question. Not all income is taxed the same. Long-term capital gains, for example, are taxed at a rate of between 0% and 20%, depending on your income level.
A taxpayer with $1 million in income, half of which is capital gains, will pay significantly less taxes than another with $1 million in ordinary income. Tax strategies that can "convert" ordinary income to capital gains can potentially result in big tax savings. "To determine if they make sense, you have to compare the capital gains rate with the marginal tax rate," said Losi.
The third source of difference between marginal and effective tax rates is the enormous number of legitimate deductions and credits available to taxpayers — particularly those who own businesses — in the US. tax code. For individuals, the items include tax-deductible contributions to a pension plan or health savings account, tax credits for dependent children and charitable contributions. For businesses, the number of items is exponentially larger.
The CARES Act dramatically expanded the number of options available to business owners to reduce their current tax liability or increase their eligibility for cash refunds. While minimizing taxes is the goal of tax planning, it is rarely cut and dried which strategies will get you there.
For example, Section 179 expensing rules — dramatically enhanced by the Tax Cuts and Jobs Act in 2017 — allow businesses to accelerate the depreciation of new assets purchased for tax purposes. That's great for lowering current taxes but perhaps not for tax liability over an extended period. The deductions may be more valuable when a business owner is in a higher marginal tax bracket or a "C" corporation is facing a higher statutory tax rate as many tax experts expect in the Biden administration.
"Maybe 90% of the time, it's the right thing to do," said CPA Tom Gibson, senior tax strategist for Tax Saving Professionals. "But if you spend a dollar to save 24 cents now as opposed to 37 cents down the road, it doesn't make sense.
"It may be better to depreciate those assets over seven years not one."
The art behind the tax-planning effort is to consider each individual's or business' particular circumstances over an extended period and to incorporate expectations about potential tax policy changes in the future. "We generally use marginal tax rates to assess particular tax strategies," said Gibson. "If the marginal and effective tax rates are close to each other, it suggests you're not doing much tax planning.
"My job is to get the effective tax rate as low as possible."