Question: Can you please explain the differences between effective and marginal tax rates?
A BuyandHolder

Answer:

Dear BuyandHolder,

Marginal vs. Effective Tax Rates

You’ll want to be familiar with these 5 points as you start to do your tax return or before you talk with your accountant.

1)   The effective tax rate

Recently Republican presidential candidate Mitt Romney revealed that he pays approximately 15% in taxes. The statement caused confusion among some, perhaps among many. Romney was not referring to his tax bracket as some people thought, but rather to his effective tax rate. The effective rate is the amount paid in taxes as a percentage of one’s total income.

2)   The progressive tax system

In this country we have what is known as a progressive tax system – one in which our income is taxed at graduated, not flat, rates. Therefore, as your income “progresses,” your rate of taxation “progresses;” in other words, it increases.

Because not all income is treated equally, you actually wind up paying less on the first dollars of your earnings and more on your last dollars – last dollars meaning highest dollars of earnings.

3)   The marginal tax rate

The marginal tax rate refers only to the percentage of your income that is taxed at the top rate -- and not the effective rate for one’s total income.  The marginal tax rate is the highest rate you pay on part of your taxable income – that part being, as mentioned in Point #2, your last or so-called highest dollars of taxable income.

4)   Tax brackets

A tax bracket (also referred to as the marginal tax rate; see above) is the point on the income tax rate schedules where your taxable income falls – that is, income subject to tax after exemptions and deductions.

It is expressed as a percentage to be applied to each additional dollar earned over the base amount for that bracket. It is not the rate for the entire amount.

Currently, the tax brackets are: 10%, 15%, 25%, 28%, 33% and 35%. (These brackets periodically change.) Your bracket not only depends upon your income but also upon how you file: as a single, as a married couple filing joint, as a widow or widower, as a married person filing separately or as the head of household.

5)   Adjusted gross income (AGI) This is the income on which your federal income tax is based. The dollar amount is determined by subtracting from your gross income any unreimbursed business expenses and other deductions – such as IRA and Keogh contributions, moving expenses, alimony payments or disability income. AGI is also an individual’s or a couple’s income before itemized deductions – such as medical expenses, interest payments and real estate taxes.

For Further Information: www.irs.gov

Good Luck!