Marginal vs Average Tax Rates

Let’s have a quick discussion about taxes. I just want to share a couple of important concepts, but not everyone fully understands them. It is simply an explanation of two tax rates that apply to everyone paying income taxes.

First, we have the Marginal Tax Rate. In its simplest form, this is the tax rate on the last dollar you earned. Another way it is explained is what is the tax rate on the next dollar you would earn.

I am going to keep this example super simple. Let’s say your taxable income after all adjustments, deductions, etc., is a nice round $400,000 for 2024 and you file Married Filing Jointly. Under the current tax structure, your Marginal Tax Rate is 32%. Technically, every dollar from $383,901 to your total of $400,000 is taxed at this 32% rate.

The important thing to note here is the 32% rate is NOT applied to all $400,000 of income. To get that number, we turn to what is most often referred to as Average Tax Rate.

The easiest way to think about the Average Tax Rate is to take your total Federal tax bill and divide it by your total income. Most accountants prefer the Effective Rate, which is your total Federal tax bill divided by income after deductions, but I have found clients prefer to know their Average Rate.

Let’s once again look at a simple example. A married set of physicians had total income of $400,000 in 2023. Their tax bill was roughly $80,000. This means their Average Tax Rate was 20% for last year.  Some dollars were taxed at lower rates and others higher, but the overall tax rate was 20%.

I told you those were simple. However, most people do not understand them, including too many financial advisors.

There is one more tip I want to share. This comes directly from my clients. It is taking your total Federal tax bill and dividing it by twelve (12). You now know how much your monthly payment to Uncle Sam is. My clients like seeing it broken out this way for two reasons. First, before I shared this number no one, including their CPAs, ever broke it down in this manner. The next is it is easier to understand when you compare it to say your monthly mortgage or car payment. In the case cited above, their monthly payment to Uncle Sam is just under $6,700.