Effective Tax Rate: What is it?

Your effective tax rate is the percentage of your overall taxable income that you pay in taxes. “Cash” is a tax way of saying “average,” and this rate is usually considerably less than your marginal tax rate, which depends on your highest tax bracket.

Your effective rate is the average of all the various rates you will pay in increments of your income after taking the deductions to which you are entitled. A relatively easy math equation can help you figure it out.

What is an effective tax rate?

Your effective tax rate is the average of all the tax brackets the IRS uses for your income levels. To understand your effective rate, you first need to know the IRS tax brackets.

You would be in the 22% tax bracket if you earn $60,000 in 2021 and are single, but you will not pay 22% of your total income in taxes. You would pay 22% of your best dollars only, the top of $40,525 beginning in tax year 2021.

The chart below shows the effective income tax rate for single individuals for tax year 2021, the tax return you will file in 2022.

How the effective tax rate works

To calculate your effective tax rate, divide your income by the taxes you paid. What makes effective taxes complicated is that two people in the same tax bracket may have different effective tax rates.

Here is an example. Someone earning $80,000 would pay the 22% rate on $39,475 of their income over $40,525 in 2021, while you would only have to pay a 22% rate on $19,475 of your income with $60,000 of taxable earnings. However, they would both have the same marginal tax rate of 22% and fall into the same tax bracket.

You would owe $8,991 in taxes on $60,000 in income:

  • $995 on the first $9,950 at 10%
  • $3,669 on $9,951 up to $40,525 at 12%
  • $4,285 on $40,526 up to $60,000 at 22%

The taxpayer who earned $80,000 in taxable income would owe $13,390 in taxes:

  • $995 on the first $9,950 at 10%
  • $3,669 on $9,951 up to $40,525 at 12%
  • $8,684 on $40,526 up to $80,000 at 22%

The effective tax rate for the first person would be 14.92%, while the rate for the second person would be 16.67%. The second person has a higher effective tax rate because they earned $20,000 more than the first person and therefore paid more taxes.

Your effective tax rate does not include taxes you may pay to your state, nor does it take into account property taxes or sales taxes. It’s just what you owe the federal government for income taxes.

Knowing your effective tax rate can help with budget and tax planning, especially if you’re considering a significant life change, like getting married or retiring.

Effective Tax Rate vs. Marginal Tax Rate

The US tax system is known as a “progressive” system because it uses marginal tax rates instead of a flat tax rate. The more you earn, the higher the percentage you’ll pay on your best dollars.

With a total taxable income of $60,000, 22% is your marginal tax rate. The marginal rate applies only to your additional income above a certain tax bracket threshold amount. Your effective tax rate is the average rate you pay on the $60,000 and is a much clearer indication of your actual tax liability.

Effective tax rate Marginal tax rate
$9,950 taxed at 10% = $995 22% on income over $40,225
$30,575 taxed at 12% = $3,669
$19,475 taxed at 22% = $4,285
Average of three types: 14.92%

How to get your effective tax rate

Look at your most recently completed tax return and identify the total tax due on line 24 of the 2021 Form 1040.

Now divide the number on line 24 by what appears on line 15 (taxable income) of the 2021 Form 1040. The result of that calculation is your effective tax rate.

The IRS has redesigned Form 1040 three times recently, once for tax year 2018, again for tax year 2019, and once again for 2020. Your taxes due were on a different line in 2020 than they were in 2019.

Do you need to pay the effective tax rate on your net pay?

No, you will not pay the government your effective tax rate on what you earn during the tax year. Rather, you pay the rate on your taxable income, which is what’s left after you subtract any deductions (standard or itemized) and above-the-line adjustments from your gross income.

For example, if your gross income for 2021 was $60,000 and you took the standard deduction of $12,550 for a single taxpayer, your taxable income would be $47,450. And this assumes that you are not eligible for any other tax relief at all; You only pay taxes on the balance of your income after you take all the tax exemptions you can claim.

key takeaways

  • The federal tax system is progressive. You pay a higher percentage on tranches of your taxable income as that income increases.
  • Your effective tax rate is the average of all the percentages you pay in these income brackets.
  • Your marginal tax rate is the maximum percentage you pay on your top dollar.
  • Your effective tax rate tells you the exact percentage of your overall taxable income that you give to the IRS.

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