Marginal and average tax rate

Marginal and average tax rate

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What is the difference between a marginal and average tax rate? Even though it may not be so obvious, understanding the difference between a marginal and average tax rate can help lower your total taxes.

Knowing the difference between marginal and average tax rates is important for good tax planning.

Most countries employ so called graduated or progressive tax system. Graduated tax system is aiming higher tax rates at people with higher incomes. This means that the more you earn, the higher your tax rate will be. You can see that in the following table:

taxable income between tax bracket
0 and 8,025 10%
8,025 and 32,550 15%
32,550 and 78,850 25%
78,850 and 164,550 28%
164,550 and 357,700 33%
357,700 and above 35%

The table above shows tax brackets in the USA in year 2008 (filing status single). You can clearly see the progressivity of the tax system. Wealthy people with taxable income pay 35% on their income in the top bracket. Less fortunate people pay only 10% on their income. If you are interested in tax rates and brackets for other years, see the federal tax calculator page.

The more you make, your every additional dollar will be taxed at higher rate than your dollars in the preceding tax bracket.

Marginal Tax Rate

The marginal tax rate is the rate of tax applied to the last dollar added to your taxable income. For example, if you are making $90,000 per year (taxable income, that is total income less adjustments, deductions, exemptions), then your 90,000th dollar will be taxed at the 28% tax rate. Your 90,001th and every other tax dollar will be also taxed with the 28% rate until your taxable income reaches $164,550.

Marginal tax rate

The 28% tax rate is the marginal tax rate in this case. It is important to mention that not all income dollars will be taxed at the 28% rate. Your 78,849th income dollar will be taxed at the 25% tax rate. And so on.

Average Tax Rate

The average tax rate is calculated by dividing the total income taxes paid by your total income.

                           total income taxes paid
average tax rate (ATR) = ---------------------------
                                 total income

The average tax rate incorporates taxes paid at all levels of income, so naturally it is obvious that it will be less than the marginal rate.

Average tax rate

Note, high-income earners (taxable income over $2,000,000) will have their average and marginal tax rates close to equal.

Example: Marginal and average tax rate calculation

Let's demonstrate the concept on Joe Smith. Joe Smith is SINGLE and makes $105,000 of taxable income per year. That is his income after accounting for all deductions and exemptions.

Joe's tax in for example 2008 is the following:

$782.50 (tax on the first $7,825 of Joe's income, taxed at the 10% rate), plus
$3,603.75 (tax on the income between $7,825 and $31,850, taxed at the 15% rate), plus
$11,312.50 (tax on the income between $31,850 and $77,100, taxed at the 25% rate), plus
$7,812.00 (tax on the income between $77,100 and $105,000, taxed at the 28% rate)
(See the Tax rates schedule 2008 for more details on tax brackets.)

Joe's total tax liability is $23,510 (rounded down). His marginal tax rate is 28%. The next dollar Joe earns will be taxed at 28%.

Joe's average tax rate is calculated as $23,510 divided by $105,000. Theoretically, it would be divided by Joe's total income which in our case would be $105,000 plus any deductions, exceptions, and adjustment he may have done to arrive to his $105,000 taxable income figure. For the simplicity of this explanation, we divide Joe's tax liability by his taxable income. Joe's average tax rate is therefore 22.4%.

On average Joe is paying 22.4 cents for every dollar of taxable income he earns.

Joe's average tax rate is lower than his marginal tax rate because most of his income is taxed at lower tax rates.

Why is this important?

So, why is it important to know the difference between the marginal and average tax rate? Your goal is to decrease the difference between the two as much as possible and legally allowable.

You can read about tips for reducing the marginal tax rate at the: Marginal tax rate: How can I lower my taxes? page.

More information about taxes

In case you are interesting in reading about more tax related help, feel free to visit our taxes discussion forum or to peek at the following articles:

Expenses: section 179 tax deduction for your computer
Address change - how to notify IRS
10 tips last-minute checklist for error-free tax return

These resources might be able to help as well:

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