Confused About Marginal or Effective Tax Rates? This is how they differ

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What is your marginal tax rate? What’s Your Effective Rate?

A point of confusion for many taxpayers is the difference between the two. Both measures say a lot about a taxpayer’s financial profile and are used for tax planning purposes to weigh the aftermath of investments and post-tax transactions.

“If you are on your way to the top tax bracket, you need to use the marginal tax rate for planning,” said Ryan Losi, CPA at Piascik. “For 95% of Americans, however, the effective tax rate is the better measurement tool.”

The marginal tax rate is the tax rate charged on the last dollar of a taxpayer’s income. It also determines the value of a particular deduction for a taxpayer. For example, a dollar in deduction is worth 37 cents in tax saved for a person in the highest tax bracket of 37%. That same dollar of deductions for someone whose marginal tax rate is 24% would translate into 24 cents of tax savings.

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The effective tax rate, on the other hand, is the actual percentage of taxes you pay on all of your taxable income. This is the taxes paid divided by your taxable income. If the U.S. tax system were based on a flat tax, marginal tax rates and effective tax rates would be the same, provided that no deductions and credits are allowed and taxpayers comply perfectly with the law. Of course it is not.

The aim of tax planning is to minimize the taxes that you will pay not just this year, but over many years and ideally throughout your life. “The savvy tax planner, like a corporate vice president of tax planning, can lower an individual’s effective tax rate,” said Losi.

There are three main causes of differences between marginal and effective tax rates. The first is the progressive nature of the US tax system. There were seven tax brackets in 2020, ranging from 10% on the first $ 9,875 of income to 37% on income above $ 518,400. Therefore, a taxpayer with taxable income of $ 520,000 pays 37% tax on just $ 1,600. Its marginal tax rate can be 37%, but its effective tax rate would be significantly lower.

2020 income tax brackets

IRS

The second is the type of income in question. Not all income is taxed equally. For example, long-term capital gains are taxed at a rate between 0% and 20%, depending on income levels.

A taxpayer with income of $ 1 million, half of which is capital gains, pays significantly less tax than another taxpayer with ordinary income of $ 1 million. Tax strategies that can “convert” ordinary income into capital gains can potentially result in large tax savings. “To see if they make sense, you need to compare the capital gains rate to the marginal tax rate,” Losi said.

The third cause of the difference between marginal and effective tax rates is the enormous number of legitimate deductions and credits available to taxpayers – especially corporations – in the United States. Tax code. For individuals, items include tax-deductible contributions to a retirement plan or health savings account, tax credits for dependent children, and charitable donations. For businesses, the number of items is exponentially greater.

The CARES Act has 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 rarely cuts and dries up what strategies will get you there.

For example, Section 179 expense rules – which were greatly improved by the Tax Cut and Jobs Act in 2017 – allow businesses to expedite the depreciation of new assets purchased for tax purposes. This is great for lowering ongoing taxes, but maybe not for lowering tax liability over the long term. The deductions can be more valuable if a business owner is in a higher marginal tax bracket or a “C” corporation faces a higher statutory tax rate, as many tax professionals in the Biden administration expect.

“Maybe it’s the right thing 90% of the time,” said CPA Tom Gibson, senior tax strategist with Tax Saving Professionals. “But if you spend a dollar to save 24 cents now instead of 37 cents later, it doesn’t make sense.

“It may be better to write off those assets over a seven-year period, not one.”

The art behind tax planning efforts is to take into account the unique circumstances of each individual or company over an extended period of time and to consider expectations of possible future tax policy changes. “We generally use marginal tax rates to evaluate certain tax strategies,” Gibson said. “If the marginal tax rates and the effective tax rates are close, it indicates that you are not doing a lot of tax planning.

“My job is to keep the effective tax rate as low as possible.”

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