Taxes: Marginal & Effective Tax Rates

The 2020 tax season is upon us and so I'm busy answering tax questions for clients.

When it comes to your tax rates, it may be confusing because the U.S. tax system is progressive.

This means you have two tax percentages to be aware of: your marginal tax rate and your effective tax rate.

https://youtu.be/zjiCjgVCQoA
http://poweruptaxplanning.com/
https://www.levelupfinancialplanning.com/

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Because everyone has to pay taxes, it's good to just get a baseline understanding of some of the basics. So hopefully these will be helpful. This is Techie's Personal Finance Bootcamp where I help tech professionals in their 20s and 30s balance a great life's day without sacrificing their future possibilities. I'm your host, Lucas Casares, certified financial planner and founder of Level Up Financial Planning, where I help educate, coach, and build strategies with my clients to help them take their financial confidence to the next level. Here's an important compliance disclosure. This podcast is for informational purposes only and are not to be considered recommendations. It is recommended you consult your trusted financial professional before implementing any information obtained from the Techie Personal Finance Boot Camp. Hello, thank you for joining Techie Personal Finance Bootcamp. I know I'm supposed to be taking some time off between season one and season two, but I'm right in the middle of starting a gear up for tax season. So I do tax planning with my clients at level of financial planning, but I also launched a tax planning and tax filing called Power Up Tax Planning Services. So I'm super excited. There's a lot of common questions that people have when it comes to their taxes, and I'm going to be recording a couple of quick episodes to just kind of tackle these different things. So hopefully they won't be too long, but they will be pumped with information that hopefully you can use and just have a better understanding of how taxes work. So today's episode, I'm going to be tackling marginal tax brackets and your effective tax rates. So a lot of times people don't realize that you're probably not paying as much in taxes as you think, because a lot of times you lump in together what Social Security and Medicare and your state taxes are. But from the federal taxes standpoint, it's actually not as much as you think that you are paying. Even if you end up being in like a 24% tax bracket, you're not paying 24% on all of the income that you earn. So that's big thing to know. So your marginal tax bracket is the bracket that you kind of finally fall into. And most of the time it's just gonna be pretty cut and clear that oh, if you're in the 24% tax bracket, then that's the marginal tax rate that you have. Basically, that's any additional dollars that you earn, that next dollar is gonna be uh paid at that amount. So if it was the 24% tax bracket and you earned an additional thousand dollars and that you still stayed within that bracket, then you'd end up paying $240 because that's 24% of that thousand dollars that additional that you earn. So that's how the marginal tax bracket works. Once you get up to that next bracket, the the dollar that pushes you into that next tax bracket would make that a marginal tax bracket for 32%. So those numbers seem high, right? So 24 or 32%. And again, it's only on your higher earned income. The US tax rate system is progressive, so you actually start out paying lower taxes on the first uh few thousand dollars earned, and those things gradually increase. So uh you pay nothing uh on the kind of standard deduction that you're allowed. So if you're married filing jointly, it's double than what if you're a separate single filer. Then there's that first tax bracket that you hit, and that's a 10% tax bracket, then it's a 12%, then it's 22%, 24%, 32%, 35, and then finally 37%. So again, you're not paying that 35% or 37% on all of your income. It's just kind of as you cross these different thresholds, that income that fits in that kind of bracket ends up becoming taxed at that rate. So because you're not paying that same amount across all of your income, that's why there's a different number that is actually more relevant and uh may make you feel a little bit better. It's called the effective tax rate. So the effective tax rate is uh a little bit simpler of a calculation because you just basically take the amount of taxes that you end up owing. So uh, and I'll pull up an example here in a second, but let's say you owe $10,000 in taxes and you had $100,000 of gross income. Well, that would be 10% because you just put the taxes and divide that by the actual gross income that you generated for the year, and that makes your effective tax rate. So now we can dive into a quick example I just kind of made for this video specifically. So this is a look at a few different things. So it's an example of a couple marriage fineline jointly. Their income is $150,000 and they're saving 10% of that towards their 401k contributions, so it's $15,000 for that. That gives them an adjusted gross income of $135,000 because it reduces your taxable income if it's traditional 401k contributions. And then from there, they're able to take the standard deduction. And since they're married finally jointly, that is $24,800. If you're a single filer, it is half of that, so $12,400. So just be aware that your numbers may be a little different depending on your filance situation. So once you deduct that standard deduction from that, then your AGI minus the deductions is $110,200. So that's when you start to be able to calculate your income tax before the credits. And so you might have additional deductions that you're able to do. Uh, you might end up having different credits on what I'm showing. I'm just showing some quick, easy ones uh just for illustrative purposes, but these aren't the only things that exist that could help reduce your income or increase your income for that matter. So just make sure that uh you're not saying, oh, this is the only things I had to worry about that you may have different things going on. This is just for simplicity's sake. So income tax before credits, $15,824. That's what it would be, but uh they do have one child and the child tax credit's $2,000. So that actually takes $2,000 straight off of the income tax due. So the new total is $13,824. And by using those numbers, kind of show you their marginal tax bracket, is the 22% bracket. So if they earned another thousand dollars and still manage to stay within the 22% bracket, then they pay $220 on that additional thousand dollars. Uh or if you just want to look at it, the next dollar that you earn. So if they earned an additional dollar, they're gonna pay 22 cents in taxes on that next dollar earned. The effective tax rate, again, we're taking that actual amount in taxes they end up paying and we divide it by their gross income. So that came to 9% for uh this family. So hopefully that gives you a quick run through as far as the differences between your marginal tax bracket and your effective tax rate. Thank you for listening to Tyche Personal Finance Bootcamp. Remember, if you like what you've been hearing, to subscribe, review, and share with your friends and colleagues. You want to take your connection to the show to the next level, you can find me on LinkedIn or on Facebook. Catch you next time on TechE Personal Finance Bootcamp.