Monthly Archives: April 2012

Effective Income Tax Rate Calculations

How much do you pay in taxes? There are a vast number of answers to that question, all of which show a portion of the truth. Although most people talk about their bracket, which is the top marginal tax rate that they pay, looking at effective tax rates can be a more complete way to look at how much you spend on government.

  1. Definition of the Effective Tax Rate

    • The effective tax rate for individuals is calculated by dividing the taxes you pay by your total taxable income. For instance, if you are a married couple with a taxable income of $75,000 and file jointly, you would pay $11,000 in federal taxes in 2011, leading to an effective tax rate of 14.7 percent, based on the fact that portions of your income fell into the 10, 15 and 25 percent brackets. For business entities, the effective tax rate is determined by dividing the tax expense on the company’s income statement by the company’s pretax income.

    Components of the Effective Tax Rate

    • Effective tax rates can vary, though, depending on what you include in your taxes. For example, assume the couple listed in the previous example also spent $2,000 in state income taxes, $1,500 in property tax, $2,000 on state sales taxes, $500 in miscellaneous taxes on gasoline, phone bills and the like and $6,885 in FICA payroll tax deductions. In that case, their total tax bill would be $23,885, which, when divided by the $75,000 in taxable income, comes out to a 31.8 percent effective tax rate.

    Effective vs. Marginal Tax Rates

    • The tax brackets that most people talk about are their marginal tax rates. For instance, if you say that you are in the 25 percent tax bracket, it means that at least your last dollar of taxable income is subject to a 25 percent federal income tax, even though portions of your income are taxed at a lower rate. In 2011, only the taxable income that exceeds $69,000 (up to $139,350) for a couple filing jointly is taxed at the 25 percent rate by the IRS. For the couple with $75,000 of taxable income, $6,000 of it would be taxed at 25 percent, and the rest would be taxed at a lower rate. This can be a useful way to look at what earning another dollar will cost you in taxes, but it does not express the totality of your tax. In addition, marginal tax rates usually refer only to federal or state income taxes and not to the total amount of tax a person pays. Although they may not be useful to express a total tax bill, the marginal tax rates show the impact of tax on people’s decision to increase their income.

    Effective Marginal Tax Rates

    • Combining the two tax rates gives the best picture of the cost of earning more income. Looking not only at all your earned income at its effective rate, but also at your potential income at an effective rate tells you what you pay in taxes and what you will pay in additional taxes. For instance, while the taxpayers discussed above faced an effective rate of 31.8 percent on their first $75,000 in taxable income, their next dollar of income would face an effective marginal rate of at least 38.65 percent, based on 25 percent federal income tax, 7.65 percent FICA tax, and an estimated state income tax rate of 6 percent. If the coupled used that dollar on something subject to additional tax, their effective marginal tax rate would be even higher than the calculated 38.65 percent.

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Posted by on April 17, 2012 in Tax Relief