Marginal vs. Effective Tax Rate

Matthew Mullowney |

I am not a CPA...

Allow me to start by clarifying that I am not a credentialed tax professional or CPA, and this is for educational purposes only. However, it is vital to pay close attention to the tax code in my line of work to ensure my client is as tax efficient as possible before and during retirement. 

First, let's talk about marginal tax rates from a 36,000-foot view.

  • As of today's date, there are seven federal tax brackets for the 2020 tax year: 10%, 12%, 22%, 24%, 32%, 35% and 37%. Your bracket depends on your taxable income and filing status. These are the rates for taxes due in April on an annual basis.
  • Each marginal tax bracket coincides with a certain amount of your income that is taxed at that rate. The first amount of your income is taxed at the lowest rate of 10%; once you hit the next level of income of 12%, you pay that marginal tax rate for those dollars and so on. When calculating your household income, you may have tax deductions that will reduce your overall taxation that will not include in the initial calculations. I will be using the graphic below to explain how these calculations work.
Marginal Tax Graphic

Marginal Tax Bracket Breakdown

You can see from the above image that the tax owed is added per tax bracket, not as a total of your overall income. Let's use $175,000 to break down how this works; 

  • The first $9,875 of your income will be taxed at 10% for a total of $987.50, pretty straightforward math.  
  • The following $30,249 is taxed at 12%, for a total of $3630 in taxes.
  • The next 45,399 is then taxed at 22% totaling $9988 in taxes. 
  • Then 24% on the next $77,774 paying $18,665.
  • Now, the final tax brack for this example would be a partial amount. The income left would only be the difference between $175,000 and the bottom of the 32% tax bracket of $163,301. So, in this case, $11,699 would be taxed at 32% totaling $3,743.
  • Adding each tax bracket sumset to arrive at our total tax liability of $37,013.50, again not including any deductions.

Perception would be that if you made $175,000, you simply fall into the 32% tax bracket, and all of your income is taxed at the rate, correct? Wrong. Instead, you add the taxes you paid in each tax bracket for each set of monies to create your effective tax rate for your household. Blending your taxation on $175,000 would give you an average or effective tax rate of 21.2%.

Another twist in this math is including once your standard deduction. If you are a married couple filing jointly, standard deduction knocks your household income down by $24,400, which then puts you back into the 24% tax bracket. The amount taxed in the 24% tax bracket is now 65,074 instead of $77,774, and the calculation change brings you down to a 14.2% effective tax rate since you no longer pay 32% taxes on any of your money and less tax in the 24% marginal bracket. Phew, we did it!

Other taxes to consider when investing are taxes on non-qualified assets. Non-qualified assets are assets that do not qualify for special tax treatment like a standard brokerage account. In contrast, a qualified account or asset is an IRA or 401k. Be careful not to mix these; you could quickly pay 15% or 25% on capital gains for a non-qualified distribution which could sting without proper planning. 

I'll go into detail on capital gains in my next blog. In the meantime, you know where to find me if you have questions. 



*This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.