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Marginal vs. Effective Tax Rates - How Do They Differ?

by
Spencer Wilson
on
4/18/2021
Marginal vs. Effective Tax Rates - How Do They Differ?

The U.S. tax rules can be extremely confusing. There seems to be extraordinary complexity and exceptions built into every rule, and this has led to a need for highly skilled professionals who can guide taxpayers and help them reduce their annual tax liability. One of the areas where tax planners can be most effective is in their understanding of the difference between the marginal tax rate and the effective tax rate, and how investments and other financial transactions can be leveraged to reduce the amount that an individual owes the government.

Source: IRS

The system works in such a way that people are taxed at the rates shown on a progressive basis, so an individual taxpayer earning $400,000 in income will pay 10% in taxes on the first $9,875 of income that they earn, 24% in taxes on the amount they earn between $85,526 and $163,300, and 35% on the amount between $207,351 and $400,000. That 35% on the last $192,649 that they earn is what is known as the marginal tax rate: it is the rate that the government assesses on the highest bracket within which you earn. The marginal tax rate is different from the effective tax rate, which is the actual percentage of taxes you pay on all of your taxable income. You can figure out your effective tax rate by dividing the taxes that you owe by your taxable income. For the 5% of Americans who earn at the highest income levels, knowing what their marginal tax rate is can help them minimize their tax liability by taking advantage of different credits, deductions and other tax-saving tools.

The higher your marginal tax rate is, the more valuable a tax deduction or credit becomes. That is because people who are in the highest tax brackets pay 37 cents on every dollar that they earn, where people in lower brackets pay less. The savings become more and more valuable because the more you can lower the amount you pay in the top bracket, the lower your effective tax rate will be. There are several different ways of impacting the effective tax rate, including converting normal income into long-term capital gains income, which is taxed at a rate between 0% and 20% instead of at the tax rate shown above. This means that if somebody earns a salary of $1 million, they are going to pay much more in taxes than somebody who earns $500,000 in salary and $500,000 in capital gains. A tax planner can help an individual lower their effective tax rate by suggesting a strategic use of investments that reduces their marginal taxes.

The other way that an experienced tax planner can help is through the use of credits and deductions. This can be especially effective for business owners, for whom many more of these are available as a result of the CARES Act, though individual taxpayers are also able to lower their tax rates through credits for charitable contributions, child tax credits, and by contributing to pension plans and health savings accounts that effectively lower their taxable income level.

Tax planning and taking advantage of the many rules regarding credits and deductions is far from straightforward. It can be confusing, particularly in areas like depreciation of new assets as described under Section 179 expensing rules.

When the Tax Cuts and Jobs Act passed in 2017, it seemed clear that businesses could increase the depreciation rate, thus creating a greater tax benefit and lowering the amount of taxes paid in a given year. But the long-term view may not be as beneficial. Much will depend on the business owner's marginal tax rate or whether the company is a C corporation, and therefore may be looking at a higher statutory tax rate in the future.

It is examples like this one that makes it essential that you seek the help of a tax planning professional, who can look at both the short-term impact of tax policies and the long term. Tax planners are dedicated to understanding what the current rules are and what effect they will have in the future and using that understanding to lower their clients' marginal and effective tax rates. You can tell how effective your tax planning strategy is by comparing your marginal rate to your effective rate. The closer they are to one another, the less impact your strategy is having and the greater your need is for professional tax assistance.

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Spencer Wilson

Spencer Wilson

Spencer Wilson, EA is a tax preparer based in Long Beach, CA. Spencer Wilson Financial Management Services has been serving the Greater Los Angeles Area and Orange County since 2004. <br /> We began in the heart of Naples in Long Beach and we continue to work hard offering tax preparation and planning, business accounting and bookkeeping and payroll services . <br /> We have helped many different people and businesses succeed financially and take control over their finances.

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