What are Effective and Marginal Tax Rates? 

In this Blog, we will unravel the mysteries of two crucial tax concepts: marginal tax rates and effective tax rates. Many people find these concepts perplexing, but fear not; we'll break them down for you. Plus, we'll tackle the common misconception about tax brackets. So, let's dive right into it!

Firstly, let me introduce myself. I am  Faisal Khan, a Tax accountant specializing in helping real estate professionals, small business owners and independent contractors save a bundle on their taxes. But today, this Blog is for everyone, whether you're a business owner or not.

To make these concepts crystal clear, let's use an example. Picture an individual who earned $117,400 – this could be from working for an employer or running a small business. After accounting for their expenses, which might include dividends and interest income, their adjusted gross income (AGI) stands at $112,400. AGI is essentially your gross income minus any allowable deductions.

Now, we face a choice: take the standard deduction or itemize deductions. Thanks to the Tax Cuts and Jobs Act, the standard deduction got a significant boost, making it challenging for most Americans to surpass this threshold. So, in this example, our taxpayer opts for the standard deduction.

At this point, we've arrived at taxable income. We started with gross income, deducted adjustments to reach AGI, subtracted the standard deduction, and now we're left with $100,000 in taxable income. However, here's the kicker: not every dollar in the U.S. tax system is taxed at the same rate. This is where tax brackets come into play.

In our scenario, the individual is single, and their first $9,875 is taxed at 10%. That's $987. It continues, with portions of their income falling into different brackets, such as the 22% bracket. The last bit of their income falls in the 24% bracket, which means they paid $3,474 in taxes on that portion.

Now, here's where things get interesting. There's a widespread misconception that being in a 24% tax bracket means you pay 24% on your entire income. But that's not the case. Your tax is the total of these amounts, which in this example is $18,079.

But what about the marginal tax rate? Simply put, it's the rate at which the last dollar of your taxable income is taxed. In this scenario, if our individual earned one more dollar, they'd pay 24% tax on that additional dollar. It's all about that last dollar.

Now, what about the effective tax rate? This is where things can get a bit complex, but the most common way to calculate it is by taking your total taxes paid and dividing it by your adjusted gross income. In this example, the effective tax rate is 16.1%. That's $18,079 divided by $112,400.