Marginal or Effective? Defining Tax Rates

I talk with a lot to people about their taxes in my San Rafael office, both as individuals and as small business owners — and one very common misunderstanding people present to me is when they say they know their tax rate.


Learn the Difference Between the Two Tax Rates

The reason why this statement is a misunderstanding stems from the fact that no tax rate actually exists, at least in the sense of a single term. There’s a marginal tax rate and an effective tax rate, and they are two very different things that aren’t interchangeable with each other.

In sports terms, let’s consider a baseball player. As a batter, that player has two separate numbers: a batting average (which calculates the number of hits per at-bat for the player) and an on-base percentage (which calculates the number of on-base instances per at-bat while factoring in walks, hit-by-pitch, and sacrifice flies). Those two numbers tell roughly the same story but are take different factors into account — and in some cases, can skew the perception of a player.

Marginal tax rates and effective tax rates face the same issue. Let’s go with a strict definition below, then we’ll examine it more in a real-world circumstance.

  • Marginal Tax Rate: The percentage at which your income is taxed for every dollar above a specific threshold in the tax bracket.
  • Effective Tax Rate: The overall percentage of your income that is taxed. This number includes the baseline tax number for your tax bracket plus the additional numbers charged in the marginal tax rate.

For a look at what the tax brackets mentioned above are for the 2018 tax year, see this guide from the Motley Fool.

A Tax-Rate Example

Let’s look at an example on how to calculate the numbers involved here. We’ll assume that Heather is a professional tax attorney filing single with one daughter. Her base salary is $90,000 a year, and she has earned one child tax credit of $2,000 because her daughter is fifteen years old. To keep things simple, let’s assume that she has no deductions.

Thus, Heather’s $90,000 salary falls squarely in the taxable income range of $82,500-$157,500. This has a base tax payment of $14,089.50, with further taxable income calculated at 24% for every dollar above $82,500. That means that the calculated tax in addition to the base number is 24% of $7,500 (subtracting $82,500 from $90,000), which comes out to $1,800. Thus, Heather’s owed taxes for the year is $14,089.50 (base) plus $1,800 (calculated at marginal rate) for a total of $15,889.50. That makes her effective tax rate (the percentage calculated when weighing that total against her annual salary) 17.6%. However, because she has a $2,000 tax credit, the final tally due for her is $13,889.50.


Still Confused About Tax Rates?


For people in Marin County, if you’re still not sure about how these different tax rates apply — or how a greater understanding of them can help you manage your upcoming tax planning in a smarter way — I invite you to visit the San Rafael office of Books in Balance.

As an Accountant, a significant part of my job is to look ahead. This allows us to make an informed and effective plan for filing before next April’s tax deadline. Get in touch today and receive your initial consultation for free; I promise it will be much more than “marginally effective.” (Yes, that’s a tax professional’s sense of humor.)

Brandon Dante
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