Marginal vs. Average Tax Rates: They Both Matter

Jonathan Clements for Citibank writes: Do  you know your federal tax rate? If you answered something like 25%, 28%, or 39.6%, you’re correct—up to a point. That may be your marginal tax rate, which is the rate you pay on the last $1 that you earn. But if you want to know where you stand tax-wise, you also need to know your average rate. As you finish up your federal tax return, you might take a moment to do the calculation. Your average, or effective, tax rate is simply your total federal income tax bill divided by your total income. Let’s say you’re married filing jointly and you’ll earn $100,000 in 2013, all of it earned income. If you claim the standard deduction, that will lower your taxable income by $12,200. Each spouse also gets a personal exemption of $3,900, for an additional reduction of $7,800. Add those up and your taxable income would be $80,000. That’s enough to put you in the 25% marginal tax bracket.

But the federal income taxes owed on your $100,000 would be $11,857.50, equal to 12% of your total income and 15% of your taxable income. The total tax bite on your income would be somewhat larger once you figure in state and local income taxes, and also Social Security and Medicare payroll taxes. In addition, you may be contending with other taxes, such as property and sales taxes.

So when should you pay attention to your marginal rate—and when should you consider your average rate? Your average rate can be useful when thinking about budget-related issues, such as how much monthly disposable income you’ll have and how big an emergency fund you need. Let’s say you wanted enough set aside to cover your expenses if you were out of work for six months. Without any earned income, you wouldn’t have to pay nearly so much in taxes, but the best indication of the tax savings would likely be your average tax rate, not your marginal rate.

Meanwhile, your marginal rate can help you figure out the tax savings from, say, making tax-deductible contributions to an IRA or having tax-deductible mortgage interest. Your marginal rate can also help you weigh whether to buy taxable or tax-free bonds. The reason: These financial steps can add to, or subtract from, your regular income—and the impact can usually be gauged by looking at your marginal tax rate.