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What Is An Effective Tax Rate
An effective tax rate represents the average rate at which a company or individual pays taxes to the tax authorities.
In other words, when you take a person or company’s income from all sources and calculate the total amount of taxes that are owed, the percentage of the taxes owed over the total income will represent the effective tax rate.
For individuals, the effective tax rate represents the combination of how much taxes they are required to pay on earned income (such as salary and wage) and unearned income (such as investment income).
For corporations, the effective tax rate represents the average tax rate it is required to pay on its pre-tax income.
Keep reading as I will further break down the effective tax rate and tell you how to calculate it.
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Why Is Effective Tax Rate Important
Understanding your effective tax rate can help you determine how much taxes you will potentially need to pay.
All taxpayers earning taxable income must pay taxes to the IRS.
However, everyone is subject to different tax rules, can take different tax deductions, and get various credits all affecting the effective tax rate.
An individual who knows his or her effective tax rate can make the proper adjustments to their income tax withholding amount to ensure the right level of taxes is paid throughout the year.
Another reason why it’s important to know your effective tax rate is that you will be in a better position to assess different investment options.
Depending on how your investment affects your taxable income, you may end up paying taxes above or below your effective tax rate.
Ultimately, everyone’s objective is to maximize your return by legally finding ways to reduce your effective tax rate.
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How To Calculate Effective Tax Rate
Calculating your effective tax rate is not very complicated.
Here is the effective tax rate formula:
Effective Tax Rate = Total Tax Liability / Total Taxable Income
As you can see from this formula, what you need to do is to take the total amount of tax that you are required to pay and divide that by your total taxable income.
The more taxes you pay, the higher your effective tax rate.
Conversely, the less taxes you pay, the lower your effective tax rate.
Individuals can take their 1040 Form to identify their total taxes and total taxable income so they can figure out their effective tax rate.
Corporations can look at their financial statements and take their total tax expense and divide that by their earnings before taxes.
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Effective Tax Rate Example
Let’s look at an example of an effective tax rate to better understand the concept.
Let’s assume that you live in a jurisdiction where you are taxed in the following manner:
- Income between $0 and $50,000 taxed at 10%
- Income between $50,001 and $100,000 taxed at 15%
- Income between $100,001 and $200,000 taxed at 20%
- Income over $200,001 taxed at 25%
Imagine that you have two people where Person 1 earns $175,000 per year and Person 2 $275,000.
Let’s calculate each of their effective tax rates.
Person 1 will pay $5,000 on the first $50,000 income, $7,500 on the next $50,000 of income, and $15,000 on the next $75,000 income (giving a total of $27,500 in taxes).
Person 2 will pay $5,000 on the first $50,000 income, $7,500 on the next $50,000 of income, $20,000 on the next $100,000 of income and $18,750 on the last $75,000 portion of income (giving a total of $51,250).
So, Person 1 earned $175,000 and paid $27,500 in taxes leaving a net income of $147,500.
Person 2 earned $275,000 and paid $51,250 in taxes leaving a net income of $223,750.
Person 1’s effective tax rate is 15.7% ($27,500 / $175,000) and Person 2’s effective tax rate is 18.6% ($51,250 / $275,000).
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Effective Tax Rate vs Marginal Tax Rate
What is the difference between the effective tax rate and the marginal tax rate?
In the United States, the government uses progressive taxes to determine an individual’s tax liability.
This means that a person earning less will pay less taxes than a person earning more.
A person’s income is divided into different “brackets” and each bracket is allocated a tax rate.
For instance, the table below shows the different tax brackets and tax rates applicable to each bracket as of 2021 in the United States for individuals:
Rate Single filers Married couples filing jointly Heads of households
10% Up to $9,950 Up to $19,900 Up to $14,200
12% $9,951 to $40,525 $19,901 to $81,050 $14,201 to $54,200
22% $40,526 to $86,375 $81,051 to $172,750 $54,201 to $86,350
24% $86,376 to $164,925 $172,751 to $329,850 $86,351 to $164,900
32% $164,926 to $209,425 $329,851 to $418,850 $164,901 to $209,400
35% $209,426 to $523,600 $418,851 to $628,300 $209,401 to $523,600
37% $523,601 or more $628,301 or more $523,601 or more
If a person earns $50,000, the person’s marginal tax rate will be 22% as he or she falls into that tax bracket.
However, the person’s entire income will not be taxed at 22%.
The person will pay 10% on the first $9,950, then 12% on the next $30,575, and 22% on the next $9,475 of income.
The person therefore pays:
- 10% of $9,950 = $995
- 12% of $30,575 = $3,669
- 22% of $9,475 = $544.50
The person’s total taxes payable is $5,208.50 representing an effective tax rate of 10.4%.
As you can see, even though the person’s marginal tax rate is 22%, he or she has an effective tax rate of 10.4%.
Effective tax rate measures the percentage of your total tax liability over your taxable income and marginal tax rate represents the highest tax bracket where your income situates you.
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Takeaways
So there you have it folks!
What does an effective tax rate mean?
In a nutshell, the effective tax rate is the measure of the percentage of your total taxable income that you pay to the IRS.
To determine your effective tax rate, you’ll need to take your total taxable income for the year and divide it by your total taxes payable.
Every person and company may have a different effective tax rate as they may qualify for different deductions, be entitled to tax credits, and have different levels of income.
Knowing your effective tax rate is not only good to plan your tax liability ahead of time but also to make better financial and investment decisions.
Now that you know what an effective tax rate is and how it works, good luck with your research!
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