Marginal versus effective tax rates

Remember the tower of taxable income? At each higher level of the tower, the income within that level is taxed at a progressively higher rate. But the income at lower levels remains taxed at that level’s rate.

Say you’re a single filer with $89,075 in taxable income. Then you’ll have $15,214 in tax:

• $1,028, or 10% of $10,275, the first floor
• $3,780, or 12% of $31,500, the second floor
• $10,406, or 22% of $47,300, the third floor

Because your income reached the third floor, or the 22% tax bracket, we say your marginal tax rate (MTR) is 22%. Your MTR is the rate at which your top dollar of taxable income is taxed.

But because of the way tax brackets work, only the income within that tax bracket’s range is taxed at that rate. Income at lower brackets is taxed at the lower rates of those lower brackets.

So instead of worrying about your MTR, we actually focus on your effective tax rate, or ETR. ETR is the percentage of taxable income you pay in tax.

In this case, your ETR would be 17.1%, or $15,214 ÷ $89,075. That’s much lower than your MTR of 22%, because almost half of your income is taxed at a lower rate.