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The recent tax legislation triggered a thought. Do taxpayers understand the difference between their marginal tax rate and effective tax rate?
I see the focus on the tax on the next dollar earned – marginal tax rate as opposed to what I view as actually mattering – the effective tax rate.
There is a big difference between their two. Are seniors overestimating the net impact on the new $6,000 deduction?
My associate Gemini explains it like this:
I see the effective tax rate as the most relevant. The average speed reflects how long it takes to reach your destination and may also reflect better driving efficiency.
Would I turn down a bonus or raise because it pushes me into a higher tax bracket? I never did. Last year my effective tax rate was 18% – less than my highest bracket do to deductions, our ages and tax free income. While a large income increase may affect that number, the effective rate and not the marginal rate seems most important in terms what percentage of my income I get to keep.
I have read the marginal tax rate tells you the tax impact of your next financial move. But is that really accurate? Isn’t the only measure of the net tax impact your effective rate? Shouldn’t my next move consider the real bottom line?
Since I claim no expertise on taxes or tax planning, let’s discuss.
Marginal is important for planning. If you have no desire to plan, effective is your rear view mirror.
It’s not like if your effective rate is say 17% and you have a windfall of $1M in taxable income, that your effective rate stays at 17%. Instead the margins would interest you more.
But I’m sure there are situations where the effective rate is what you want to think about.
If I received a windfall, I’d want to know how much I get to keep no matter how determined.
What do you mean “no matter how determined”? There isn’t a choice – you follow tax law. If it’s ordinary taxable income you follow the tax brackets, which provide the marginal rates for various brackets.
How the tax is determined
Yes and the margin is where that would be calculated! That’s the point of a progressive tax system.
A change in the marginal rate can have an adverse effect on the effective rate. For this reason many people pay attention to the marginal rate first.
My comment won’t add much to the conversation, but think of this: We might stretch the idea of an effective tax rate over several years. instead of limiting it to just one tax year. We can follow decisions about when to take income from several possible sources to avoid a large marginal tax rate hit in any one year, hoping to maximize our tax savings over our lifetime. This tax-planning strategy can even be pushed into the next generation.
Jonathan gives us a couple of articles for thought:
https://humbledollar.com/money-guide/managing-your-earnings/
https://humbledollar.com/money-guide/taxes-in-retirement/
Of course, looking at your opening sentence, most folks are not able to plan their taxes. They’re just happy to get a few extra dollars to help them get through the current year.
Ed: I’d also encourage readers to read this short section.
My formal logic is rusty, but I think this question falls into the category of a false dichotomy, or false choice. Effective tax rate and marginal tax rate are inexorably connected. They are both an output, or feature, of your tax return. You may look at either depending on the question or decision you are considering,
Turbo Tax defines effective tax rate as your total tax bill divided by your taxable income. Your marginal tax rate is the amount of additional tax paid for every additional dollar earned as income.
Because the tax code is not that simple, additional income cold be classified as earned income, capital gains, qualified dividends, self-employed income, or some other forms. Each of these may be subject to a different tax rate, depending on their type, and the rest of your return. Because of the way some tax provisions interact, your marginal tax rate can be effectively higher than just the tax bracket rate, say by pulling more SS income into a taxable category.
Say you add additional income to your return that pushes you from the 12% to the 24% tax bracket. The additional tax at the 24% rate will increase your effective tax rate – that’s just an algebraic fact.
If someone sells an equity that produces a long term capital gain, that gain is income subject to a capital gains tax. if they are in a low tax bracket, the tax rate on the gain could be 0%. So the additional income would lower the effective tax rate, since there is zero tax on the gain.
So it doesn’t make sense to ask which one matters more. They both matter, are connected, and a result of the same tax return.
I wonder if that definition is accurate although I know it is what many sources use.
Why isn’t it total income and not just taxable income. In my case income includes muni bond interest that is not taxable even though it is income as valid as taxable interest. What about a QCD? That too is non taxable income?
Added income that raises the marginal rate also raises the effective rate. I get that, but isn’t what is most important to the taxpayer, how much of total income they get to keep in their pocket?
I referenced Turbo Tax’s definition because you have written that you use it. I assume you reference the effective rate they provide in their summary.
With regard to what’s “most important”, that’s for each of us to figure out. A number of folks have responded that they are planning Roth conversions to set up a better future tax situation for themselves, their spouse, or their heirs.
I also think that tax planning in retirement is quite different for many retirees. While working, many have a fairly steady income and plan appropriately- think 401ks, HSAs, IRAs,. In retirement, many retirees depend on withdrawals from their savings Their total income is a choice, not necessarily a consistent number. Many factors can play in. While managing my mother-in-laws finances, we looked at multiple withdrawal scenarios to use up her extensive medical deductions. We were able to essentially convert her IRAs to after-tax accounts at little or no federal tax. There were state taxes, however.
Actually I calculated the effective rate myself using total income. That was within the ability of my basic math skills.
Looking at your comments, Dick, I fear we’re heading into Quinnland, where you keep banging the table for your point of view, while ignoring all those who say you’re wrong.
No, not everybody needs 100% of their pre-retirement income in retirement.
Yes, some folks find budgets are useful.
Ditto for your marginal tax rate. If you don’t know it, you could make a big financial move — selling a chunk of your portfolio, making a Roth conversion — that results in a massive, wealth-destroying tax bill. Knowing your effective tax rate may not prevent such a mistake. End of story.
Perhaps I have too much Socrates in me. I keep asking and probing trying to learn and understand.
Maybe all the discussion opposing my views helps readers be persuaded to follow the traditional, the right path, or validate their strategy, not mine. Many comments seem to indicate that.
Socrates came to a bad end.
Yeah, Partly because it was asserted that Socrates was leading young men astray, encouraging them to question authority, and to disregard traditional Athenian values and institutions.
yikes, questioning conventional thought and ideas. Now who would do that?
That seems to be an over-simplification. Interesting view of the trial here and here.
Well explained
For five years prior to retirement, and the seven years which have passed since retiring, I focussed on two numbers: portfolio value, and net cash flow. The net is determined by my effective combined federal and state rates, which are derived from the marginal rates charged by each. Both are relevant.
Marginal rates can be very important in retirement income decisions. I wrote about this a few years ago.
Rick, the article talks about income cliffs related to IRMAA and certain NJ pension benefits. I get the cliff thing.
I still don’t understand why marginal tax rates are more important to an individual than their effective tax rate.
If I hit a new bracket, only the income above that is taxed at a higher rate, right? There is only a 2% difference between $206,700 and $394,600 (married).
Richard…the marginal tax rate is important in the decision making process. It is important to know that for planning
You may decide to make decision to sell an equity in a year where your marginal tax rate is lower therefore keeping more of those dollars on that equity sale. I agree the effective rate is the one that matters most, but knowing what my marginal rate is in a given year helps me with planning especially if there is equity that you are planning on selling for income.
I agree that marginal doesn’t matter much when getting a raise or bonus
In David’s example below, when calculating a Roth conversion, marginal becomes an important consideration.
When you are managing your finances, good practice means you should try to minimize the amount you pay with every decision you make. Over each taxable year, this will produce the lowest possible total tax while you live the life that you desire. From a decision making point of view, the actual effective total tax rate is not important.
And, there is a lot more in the tax code than just the income tax brackets and that is why many people have to hire a tax expert to help them manage their finances.
Politeness prevents me from criticizing your speed of trip analogy. I am sure that when you make your own decisions about things like dealing with a sale of any financial asset, or a home, or whether or not to do a Roth Conversion, or a myriad of other choices, you are not thinking about your effective tax rate; you are thinking about minimizing the actual amount of tax you will need to pay as a result of that transaction.
Indeed, I would challenge you to identify one decision in which the effective tax rate would have any bearing.
Hey Dick,
If this is in response to my article posted late last night here is my response.
You write,”I have read the marginal tax rate tells you the tax impact of your next financial move.“
This is true in my case because the change in the tax law will allow me to convert 12K more dollars in the 12% tax bracket. I am trying to avoiding taxable income which would put me in the nearly double tax rate of 22%. If it weren’t for the change I would be converting 12K less per year to minimize the tax.
If my calculations are correct that amount for married filing jointly would be $142,150.
I would appreciate one of our multiple tax experts here on Humble Dollar confirming or correcting my assumptions.
Me too, because I can’t see how anything but the actual rate means much, but again I am not the expert.