Marginal Vs Effective Tax Rates
At Protego Advisers, we help entrepreneurs reduce their taxes to keep more of what they earn. During our tax planning meetings, clients often ask about the difference between marginal and effective tax rates, especially during our Q4 discussions. Both terms describe how much tax a person pays, but they are calculated differently and serve distinct purposes in tax planning. Understanding these two rates can help you make better decisions about your finances and tax strategy.
The marginal tax rate refers to the rate at which your next dollar of income will be taxed. Essentially, it is the tax rate applied to the last or highest dollar of income you earn. This is crucial because the U.S. tax system uses tax brackets, meaning income is taxed in layers, with higher rates applied to higher income levels. The marginal tax rate is often referenced in situations where we look at incremental decisions, such as making contributions to retirement accounts or purchasing big-ticket items. These decisions can impact your tax liability and influence the tax savings you might gain.
On the other hand, the effective tax rate is the average rate at which your total income is taxed. It’s calculated by dividing your total tax liability by your total income. The effective tax rate provides a more comprehensive view of your overall tax burden because it considers all income across multiple tax brackets. This is the rate we typically reference after the tax year, as it gives a clear snapshot of your total tax liability and helps you assess your overall financial situation. Understanding both rates is essential for making informed tax decisions throughout the year.
About Protego Advisers:
We specialize in crafting strategic plans that help businesses minimize their overall tax liabilities while strictly adhering to legal standards. The U.S. tax system is one of the most intricate and historically complex financial frameworks in the world. Our expertise allows us to navigate this system on behalf of our clients, enabling them to retain more of their earnings with confidence and compliance.