When I complained to my co-worker that my salary increase means that I will be taxed at a 30 percent marginal tax rate, he told me my “effective tax rate” is actually much lower. What’s the difference between the marginal tax rate and the effective tax rate?
Your marginal tax rate is the maximum rate you will pay on your taxable income, however, it’s not the rate applied to all of your income. When you look at the 2014 federal income tax brackets, this is an example of what your marginal tax rate will show:
If your taxable income is over $186,350 but not over $405,100, the tax is $45,353 plus 33% of the excess over $186,350.
Translated, that means only those dollars you earn over $186,350 are taxed at a rate of 33%. Some portion of your income is taxed at each step of the tax rate ladder–10%, 15%, 25%, and 28%– before it’s taxed at your marginal (highest) rate. So, if your taxable income is $200,000, less than $14,000 is actually taxed at the 33% marginal tax rate. In this example, since most of your income will be taxed at rates lower than 33%, your effective tax rate will be lower than your marginal tax rate.
Even your effective tax rate may not reflect the actual amount of taxes you pay. If you are eligible for tax credits that can reduce your tax dollar-for-dollar, your net tax owed can be less than your effective tax rate.
From a planning standpoint, you should focus on your marginal tax rate when there’s a possibility of an increase in your taxable income. To avoid getting bumped up into a higher marginal tax rate you may want to consider deferring some income, or finding ways to lower your taxable income. However, for cash flow planning purposes you need to focus on your effective tax rate.
Do you have a retirement question you would like to see answered? Let us know with the comment form below!
[contact-form][contact-field label=’Name’ type=’name’ required=’1’/][contact-field label=’Email’ type=’email’ required=’1’/][contact-field label=’Comment’ type=’textarea’ required=’1’/][/contact-form]