Understanding Tax Rates: Marginal vs. Effective Explained

Understanding tax rates is crucial for making informed financial decisions.

### Understanding Tax Rates: Marginal vs. Effective and Their Impact on Financial Decisions
* 💰  In the United States, we have a progressive tax system where tax rates increase as income rises. It's important to distinguish between **marginal tax rates** (the rate on the next dollar earned) and **effective tax rates** (total taxes paid as a percentage of total income).
* 💸  For example, someone earning $75,000 may be in the **22% marginal tax bracket**, but their **effective tax rate** could be as low as **15%** due to the progressive nature of the tax system.
* 📊  Different types of income, such as ordinary earned income and capital gains, are taxed at different rates. Short-term capital gains are taxed at **ordinary income rates**, while long-term capital gains benefit from **lower tax rates**.
* 🤔  Knowing your tax rates is crucial for making financial decisions, such as choosing between Roth and traditional retirement account contributions. Understanding your **marginal and effective tax rates** helps determine the **optimal strategy**.
* 📈  The decision between pre-tax and Roth contributions depends on whether your **marginal tax rate is above or below certain thresholds** (e.g., **30% for pre-tax and 25% for Roth**).
* 💡 " If you don't actually know your tax rates, if you don't know what tax bracket you're in, how will you know if you're **making that decision**?
* 🧮  Tax rates also impact decisions related to investments, estate planning, and other financial strategies. It's essential to consider both **marginal and effective rates** when making these decisions.
* 🔍  Understanding tax rates is complex but crucial for **optimizing financial decisions** and **maximizing after-tax income**.

[Music] all right Brian, let's talk about a third number that I think a lot of people don't know, and this one is fascinating to me because this one I think is so important, has such a huge impact, and I think most people are like egregiously, I don't say ignorant, that's too strong of a word, but they just don't know it, they don't recognize, I don't understand why they are, and that is your tax rates. And you notice we put that, they put s on the end, plural, not a single tax rate. There are multiple tax rates that you need to know about because, Brian, this is, I think, is so, so interesting. You know, you are a certified public accountant, that's a pretty prestigious designation. You understand the thousands of pages of tax code that we have. It's not a super simple tax system, so it's no wonder that people get confused when we talk about all the different types of tax rates. Well, yeah, we have, we live in a progressive tax system here in the United States where as your income goes

up your tax rates increase. So when somebody, when you ask somebody what their tax rate is, there's multiple. You got to get a little more detail to know because there's two big numbers out there. There is your marginal rate, which is what is the tax rate on the next dollar you earn or make. And that's the one, like I said, as we go progressive, meaning as you make more and more money, that's the one that's probably around 22% or something like that. So if you said, Hey, I pay 22% of my taxes, we like, Is that really what you pay? No, that's your marginal rate. If you go, and by the way, your federal will have a marginal rate on what the next dollar is. Your state, if there's an income tax, and that state's going to have a marginal rate of what that next dollar will be, and you'll need to add those two together. But the same person who says, I pay 22% towards taxes, that leads to the second thing they

might be talking about their effective rate, which means that you're actually, if you take what you pay in taxes and compare that to what you make in total income, that is your effective percentage. This can get so confusing that we like, we probably ought to do a case study to show people what we're talking about. That's exactly right. We said, What if you assume that someone makes $75,000 a year? Well, if we understand the way the progressive tax system works for our income tax, we have to go through the 10% tax bracket, and then we go through the 12% tax bracket, and then we go into the 22% tax bracket. So, based on income, someone earning $75,000 a year, they would be in the 22% marginal tax bracket. But that does mean that they're paying 22% in taxes when you look at the actual total amount they paid because they had to fill up those earlier buckets. They actually paid $1,553 in taxes, which would be 15% of

their income. So, while their marginal tax bracket is 22%, their effective tax rate is only 15%. So, you need to know the difference in those two numbers, and we're going to tell you in a moment why those matter because it'll affect a lot of the decisions that you make. But before we do that, there's one other thing we have to mention because this is talking about ordinary income, the earned income that we go out there and get with our jobs. There's another type of income you need to be aware of, and that's capital income. And even capital income has different tax rates. Well, yeah, I mean, if you think about this, if you own an asset for less than a year, the government treats that differently than assets that you own longer than a year, or what's known as long-term capital gains. Because if it's short-term, they're going to tax you at ordinary income tax rates. Remember, that's the higher of those marginal rates. But if you hold it longer than a year, you're an investor at

that point you probably qualify for the lower capital gains rate. So, why does this matter? Why is it important? Why do we need to know our tax rates? Well, there's a lot of decisions that we need to make that without knowing our tax rates, we likely won't make the optimal decision. For example, Roth contributions to an IRA or to a 401k versus traditional. We say all the time that the way that you determine that is you add up your marginal federal rate, your marginal state rate, and if you're in a higher tax situation, that means your marginal rates are greater than 30%, then you may want to look at pre-tax contributions. If you're in a lower marginal bracket, you're add up your marginal federal, your marginal state, and it's below 25%, you may want to do Roth. Well, if you don't actually know your tax rates, if you don't know what tax bracket you're in, how will you know if you're making that decision? Well, yeah, this comes up in so many different things. I I

love that we put together a slide that actually shows all those decisions that come in with tax rates. Also, you know, you see how this gets complicated. We have marginal rate, we have effective rate, and there's even something I'm seeing out there where people are comparing taxes to net worth. Remember, we're in an income tax situation, so it's an income tax rate, not a net worth tax. That gets much more complex, and that's why you need to understand the context of how taxes work to get it right.

Most People Do NOT Know This Financial Number (And They Should)

Bring confidence to your wealth building with simplified strategies from The Money Guy. Learn how to apply financial tactics that go beyond common sense and help you reach your money goals faster. Make your assets do the heavy lifting so you can quit worrying and start living a more fulfilled life.

Subscribe today to stay up to date with our latest episodes, livestreams, and highlight videos: https://www.youtube.com/c/MoneyGuyShow?sub_confirmation=1

Are you ready to go beyond common sense when it comes to your money? Check out all the free resources The Money Guy Show provides: https://moneyguy.com/resources/



The Money Guy Show

due to the progressive tax system, where rates increase as income rises.

The marginal tax rate is the rate on the next dollar earned, and it can vary for federal and state taxes.

Many people confuse their marginal rate with their actual tax burden, leading to misunderstandings about how much they truly pay in taxes.

The effective tax rate is the percentage of total income paid in taxes, while the marginal tax rate is the percentage applied to the last dollar earned.

For someone earning $75,000 a year, the marginal tax rate is 22%, but the effective tax rate is only 15% after accounting for earlier tax brackets.

Additionally, capital income is taxed differently, with short-term gains taxed at ordinary income rates and long-term gains at lower rates.

Knowing your tax rates is crucial for making optimal financial decisions, such as choosing between Roth and traditional IRA or 401k contributions.

A higher marginal tax rate (over 30%) may indicate a need for pre-tax contributions, while a lower rate (below 25%) could favor Roth contributions.

Without understanding your tax brackets, it's challenging to make informed decisions about your financial strategy.

Understanding Tax Rates and Their Complexity

Tax rates involve marginal and effective rates, making the system complicated.

Some comparisons are being made between taxes and net worth, but it's important to remember that we're dealing with income tax rates.

Understanding the context of how taxes work is crucial for getting it right.