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Do you know your tax bracket and corresponding tax rate? Do you find that rate depressing? Take heart — your effective tax rate is probably much lower.
A tax bracket is a range of incomes that the federal government taxes at a particular rate. There are seven tax brackets in the U.S. tax code. The federal income tax system is also progressive, meaning it taxes a larger percentage of income for taxpayers with higher incomes. This means it’s possible for more than one tax bracket and tax rate to apply to your income.
When that happens, the highest tax rate that applies to your income is your marginal tax rate. And the higher your income, the higher your marginal tax rate will likely be — anywhere from 10% to 37%. But if your marginal tax rate is 37%, that doesn’t mean you’re actually paying 37% of all your income to Uncle Sam.
Effective tax rate is a better way to understand just how much of your income really goes for federal income taxes each year. Let’s look at some things to know about effective tax rates.
Your effective tax rate, also known as your average tax rate, is the amount of federal income tax you pay — expressed as a percentage — on your earned income. While calculating the amount you’ll owe based on published tax brackets is complex, calculating your effective tax rate is simple: Divide your total federal income tax paid by your taxable income.
If you have a copy of your 2018 Form 1040 handy, you can check your effective tax rate by dividing Line 15 by Line 10.
Here’s an example: Sonia filed as single in 2018 and her taxable income from Line 10 of her tax return was $60,000, which puts her in the 22% tax bracket. Her total tax was $6,500. To get her effective tax rate, Sonia would do a simple calculation: $6,500 ÷ $60,000 = 0.108. That means Sonia’s effective tax rate is 10.8%, which is much lower than her marginal tax rate of 22%.
Whether you’re looking at marginal tax rates or effective tax rates, it’s important to know that you can reduce the amount you’ll owe by taking advantage of three things.
Adjustments to income go on Schedule 1 attached to your Form 1040. They include things like …
- Educator expenses paid by teachers
- Contributions to a health savings account
- Contributions to self-employed retirement plans
- Health insurance premiums for self-employed taxpayers
- Contributions to an IRA
- Student loan interest paid
These adjustments can be valuable. That’s because if you can take advantage of any, they lower your adjusted gross income, which might make you eligible for other tax breaks that are limited for higher-income taxpayers. Plus you don’t have to itemize deductions to claim them.
Deductions refer to either taking the standard deduction — an amount predetermined by the IRS and based on your filing status — or itemizing deductions. Itemized deductions include …
- Medical and dental expenses
- State, local income and local personal property taxes
- Home mortgage interest
- Gifts to charity (by cash or check)
- Casualty and theft losses from a federally declared disaster
Itemized deductions are reported on Schedule A attached to your Form 1040.
While adjustments and deductions lower your taxable income, tax credits are a dollar-for-dollar reduction in the amount of tax you owe. Here are some examples of tax credits.
- Child tax credit
- Credit for child and dependent care expenses
- American opportunity tax credit
- Earned income tax credit
Taking advantage of tax credits — if you’re eligible to claim them— can really impact your effective tax rate. Here’s an example.
Sean and Casey are married taxpayers who file jointly with taxable income of $117,000, putting them in the 22% tax bracket. Their total federal tax for the year was $17,457, so their effective tax rate was 14.9%. Now let’s give them a $2,000 child tax credit, bringing their total tax down to $15,457. This makes their effective tax rate 13.2% ($15,457 ÷ $117,000).
Now that you know your effective tax rate, what can you do with that information?
Most tax planning focuses on marginal tax rates, because they can help with strategies like deferring income to a lower tax year or accelerating expenses in years when the taxpayer expects to be in a higher tax bracket. Effective tax rates can help you understand how much you’re really paying compared with your marginal tax rate.
In fact, effective tax rates get a lot of publicity, because wealthy taxpayers often have lower effective tax rates than middle-class taxpayers. One reason for this is because long-term capital gains are taxed at a lower rate (no higher than 15% for most taxpayers) than the ordinary income tax rate.
For example, billionaire Warren Buffett got a lot of attention when he wrote an Op-Ed for The New York Times claiming his effective tax rate was just 17.4% of his taxable income — a lower percentage than that paid by any of the other 20 people in his office.
Knowing your effective tax rate might not do you much good from a tax-planning perspective. But it can be a useful tool for comparing the relative tax obligations among several people, and for getting perspective on just how much of your annual income Uncle Sam collects.
Regardless of whether you look at your marginal tax rate or your effective tax rate, taking full advantage of any adjustments, credits or deductions you’re eligible for can ultimately help you reduce the amount of federal income tax you pay each year.