Marginal and effective tax rates help taxpayers understand how much they owe the IRS based on their annual income and tax bracket.
- Effective tax rate: This is a taxpayer’s average tax rate, or what share of their total annual income they’ll need to pay in taxes.
- Marginal tax rate: This is the amount of tax that applies to each additional level of income. In our progressive tax system, you pay more in taxes as your income rises and a portion of your income moves into a higher tax bracket. (There are seven tax brackets for the 2021 tax-filing season, starting as low as 10 percent and topping out at 37 percent.) However, your marginal tax rate is based only on your taxable income, which is where you fall after your standard deduction or itemized deductions have been subtracted from your gross annual income. Generally, the higher income level you’re in, the higher your marginal tax rate.
A taxpayer’s average tax rate (or effective tax rate) is the percentage of annual income that they pay in taxes. By contrast, a taxpayer’s marginal tax rate is the tax rate imposed on their “last dollar of income.”
For example, a taxpayer with a taxable income of $24,750 will pay 10 percent in taxes on income up to $19,900, and 12 percent on the remaining $5,000 as a portion of the income falls into the 12 percent bracket. The marginal tax rate would be 12 percent, as the last dollar of income falls into the 12 percent tax bracket. Taxpayers’ average tax rates are lower — usually much lower — than their marginal rates.
What is effective tax rate?
Your effective tax rate tells you what percentage of your annual income you’ll owe to the IRS. To calculate your effective tax rate, you’ll need a few pieces of information:
- Your annual income.
- Your total federal income tax liability.
Once you have this information, it’s easy to figure out your effective tax rate. Just divide your total tax liability by your gross annual income (or what you earn before taxes), and you’ll get your effective tax rate. Again, this is the percentage of your annual income that you’ll pay in taxes.
Effective tax rate example
The effective tax rate will be different for every individual, based on what they make and deductions they take. But, here’s an example:
If an individual earned $100,000 and paid the IRS $25,000 in taxes, the effective tax rate would be 25 percent. You can solve for the effective tax rate by taking the amount paid in taxes ($25,000) and divide it by the annual income before taxes ($100,000). The answer: 0.25, or 25 percent. Therefore, the effective tax rate is 25 percent, which essentially means that they paid 25 percent of their income in taxes.
What is marginal tax rate?
In the United States, we use a method of progressive taxation, which places a higher tax burden on those earning more. This means that those who earn less are taxed less than those who earn more. Under this method, a taxpayer’s taxable income is separated into tax brackets (i.e., each of the income ranges in the seven brackets are taxed at different rates). So, whatever income range they fall into determines the tax rate that will be applied to their taxable income.
The brackets — or marginal tax rates — are 10%, 12%, 22%, 24%, 32%, 35% and 37%. You can find which bracket you fall in based on your filing status (single; married filing jointly; head of household, etc.) and your annual income. The following table indicates the current rates for 2021.
|Rate||Single filers||Married couples filing jointly||Heads of households|
|10%||Up to $9,950||Up to $19,900||Up to $14,200|
|12%||$9,951 to $40,525||$19,901 to $81,050||$14,201 to $54,200|
|22%||$40,526 to $86,375||$81,051 to $172,750||$54,201 to $86,350|
|24%||$86,376 to $164,925||$172,751 to $329,850||$86,351 to $164,900|
|32%||$164,926 to $209,425||$329,851 to $418,850||$164,901 to $209,400|
|35%||$209,426 to $523,600||$418,851 to $628,300||$209,401 to $523,600|
|37%||$523,601 or more||$628,301 or more||$523,601 or more|
As evident from the table above, you do not pay a fixed percentage of your entire income when it comes to your marginal tax rate. Instead, after you figure out your total taxable income, a portion of your income will fall into different tax brackets, where you’ll pay the bracket’s specified tax rate on the dollar amount of the income that falls into the bracket’s income range.
Essentially what it means is that the first dollar earned will be taxed at the rate for the lowest tax bracket, and the last dollar earned will be taxed at the rate of the highest bracket. All the dollars of income in between are taxed at the rate for the range into which it falls.
So, you go bracket by bracket, paying the percentage on the amount of income that falls within that tax bracket, until you’ve reached the bracket for which your total taxable income falls. Because of this system, your effective tax rate can be significantly lower than your marginal tax rate.
Marginal tax rate example
Marginal tax rate can best be solved by looking at the marginal tax rate chart. In the year 2021, the marginal tax rates were adjusted for inflation. Let’s say a married couple filing jointly has a taxable income of $120,000 a year. You have to go bracket by bracket to find the marginal tax rate. Here’s an example.
|Tax rate||Taxable income||Tax owed|
|10%||$0 – $19,900||$1,990 (19,900 taxable dollars x 0.10)|
|12%||$19,901 – $81,050||$7,260 ($60,500 taxable dollars x 0.12)|
|22%||$81,051 – $172,750||$8,745 ($39,750 taxable dollars x 0.22)|
In this example, the couple’s marginal tax rate would be 22 percent, as the last dollar of income taxed falls into the 22 percent tax bracket. The total tax owed would be $17,995.