What’s Your Effective Tax Rate and Why Does It Matter?

effective tax rate

When most of us talk about what “tax bracket” we fall under, we’re most likely referring to our marginal tax rate. This is the “tax bracket” your income falls under, according to the Internal Revenue Service (IRS).

However, you aren’t really taxed at that rate for your entire income.

In fact, it’s your effective tax rate that’s a more accurate reflection of what you end up paying in taxes as a percentage of your income.

If that sounds confusing to you, don’t worry, you’re not alone. Here’s what you need to know.

What is your effective tax rate?

Your effective tax rate is all about how much you’re really paying in terms of your income.

What’s more, many of the wealthy have lower effective tax rates because of the way they make their money through investments.

At the end of the day, long-term capital gains from investments are taxed at a lower rate than earned income. So if your money is making most of your money, you see a lower effective tax rate.

For example, billionaire investor Warren Buffett famously wrote an op-ed for The New York Times in which he claimed a 17.4 percent effective tax rate. That was lower than what 20 other people in his office paid.

During the 2012 presidential campaign, a big deal was made over the fact that millionaire Mitt Romney paid an effective tax rate of around 14 percent. Although Romney was within the 39.6 percent tax bracket given his income of $13.7 million, he wasn’t paying 39.6 percent of his income in taxes.

Another reason someone’s effective tax rate is likely to be lower than their marginal tax rate is because of the way tax brackets work.

You aren’t taxed at your bracket rate on all of your income. In fact, the percentage you pay in taxes is lower than what your marginal tax bracket implies.

How does the federal effective tax rate formula work?

Finding your effective tax rate by income is fairly easy when it comes to your federal income taxes.

Pull out your last tax return from the IRS and take a look at your Form 1040. Your total tax expense (line 63) should be divided by your taxable income (line 43).

Remember, your taxable income is the amount you’re actually taxed on. It’s figured out after you’ve claimed all of your deductions.

For example, let’s say my total tax expense on line 63 is $6,396. Then I divide that by my taxable income on line 43 which is $16,495. I then end up with 0.3876 and multiply it by 100 to get 38.76 percent.

Other factors can impact your effective tax rate

There are arguments that you can’t really determine your true effective tax rate until you factor in all the taxes you pay.

For instance, when using the effective tax rate formula for your federal income taxes, you don’t include what you pay in state taxes. You also don’t consider what you pay in property taxes and sales taxes.

When you figure out your effective tax rate this way, don’t forget to include what you pay for Social Security, Medicare, and other taxes. Even if you don’t pay federal income tax, you’ll still end up paying for those items.

Once you start adding up all of these items, though, it gets a little harder to figure out what your true tax rate is.

An alternative may be for you to look at all of the taxes you pay throughout the year then consider using your gross income as a starting point, instead of your taxable income.

Once you add up the dollar amount of taxes you paid during the year, divide that by your gross income. That can give you an idea of your total tax rate, based on your income.

Which method should you use?

Deciding which method you use depends on how much time you want to spend on the endeavor.

If I use all the information from my 2015 K-1 form and add up the taxes I paid when I was living in Pennsylvania and Idaho, the picture is a little different.

  • Total income = $39,469
  • State + Federal income taxes = $7,011

Now I divide 7,011 by 39,469 to get 0.1776 which I multiple by 100 to get 17.76 percent. That’s a much lower effective tax rate than my original calculation of 38.76 percent.

It’s also probably a much more accurate idea of the actual percentage of my income that I pay in taxes.

Whichever way you decide to perform your calculations, it’s important to carefully consider how to proceed. Depending on your situation, the numbers may mean different things.

At first glance, using the simplest method, it appears that I have high effective tax rate close to 39 percent. But, once I include other taxes and factors I calculate an effective tax rate of almost 18 percent. That doesn’t seem so bad.

Although it’s still higher than Mitt Romney’s.

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Published in Income, Taxes