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Being Proactive with Tax Planning – Understanding Tax Rates – Marginal vs Effective/Average vs Actual

Joe Guelda

Being Proactive with Tax Planning – Understanding Tax Rates – Marginal vs Effective/Average vs Actual

Joe Guelda CPA, Tax Manager

Your marginal tax rate is the percent of tax that you will pay on your next dollar of income based on your tax bracket. For instance, if you are married filing joint and your taxable income is $76,050, you are in the 12% tax bracket. Therefore, your next $1,000 of income will increase your Federal tax by $120. Your effective or average tax rate is your total tax divided by your taxable income. For the married couple with taxable income of $76,050, Federal tax liability calculates to be $8,728 which results in an effective tax rate of 11.48% before considering any tax credits. 

However, if the married couple distributes $10,000 from an IRA, they will pay 12% on the initial $5,000 and 22% on the next $5,000 as they are now in the 22% tax bracket. Therefore, the cost of receiving the final $5,000 will be $500 more expensive than the initial $5,000. One strategy in this scenario is to distribute $5,000 by year end and $5,000 shortly after year end.

Excluding phase out ranges of various tax credits, the biggest tax rate increases occur at taxable incomes of $40,525 single or $81,050 married filing jointly (10% increase) and $164,925 single or $329,850 married filing jointly (8% increase). The long term capital gain tax rate also increases the most at $40,400 single or $80,801 married filing jointly as the rate increases from 0% to 15%.

The difference between effective and marginal tax rates can potentially create issues when taxpayers receive bonuses, commissions, or other income resulting from infrequent or isolated events. Since withholding is typically based on average withholding, withholding could be much lower than the amount needed for additional income since additional income is subject to the marginal tax rate as opposed to the effective tax rate possibly creating an unexpected tax liability when filing the income tax return.

Now that we have discussed the differences between effective and marginal tax rates, let’s expand it even further by introducing actual tax rate. The actual tax rate is the tax rate which will apply on a specific amount of additional income. In addition to tax brackets, the actual tax rate is impacted by various phase outs applicable of both itemized deductions and tax credits. While the marginal tax rates are based on taxable income, many phase outs are based on adjusted gross income. Due to the phase out of the deductions or credits, your actual tax rate can be even higher when your income is within the phase out ranges. 

For instance, a married filing joint taxpayer with adjusted gross income of $164,000 is in the 22% marginal tax rate; however, the taxpayer is also in the phase out range of the American Opportunity Tax Credit. The American Opportunity Tax Credit phases out with adjusted gross income between $80,000 and $90,000 for single filers and between $160,000 and $180,000 for married filing jointly. As a result, 20% of the credit is phased out or $500 per child. Therefore, the actual tax rate on the income from $160,000 to $164,000 increases by 20% per child which creates additional benefit for above the line deductions (business expenses, retirement contributions, H.S.A. contributions, pre-tax insurance expenses, etc.). 

As we approach the end of the year, it becomes increasingly important to know your numbers from a tax planning perspective. In addition to knowing your numbers, it’s also important to be knowledgeable of the potential opportunities. If you are in the middle of a tax bracket, a tax decision can be as simple as this year or next based on your expectations of the following year and consideration of the time value of money; however, the closer you approach the next tax bracket or phase out range, the more important the analysis and its timing so that you can implement any decisions.