What Does “Effective Tax Rate” Mean And How Do You Calculate It?
When you pay your federal income taxes, you may assume that you simply need to know what tax bracket you fall into to review what you’re paying accurately. While understanding how the income you earn affects your tax bracket is important, it’s also important to understand your effective tax rate.
Your effective tax rate gives you a more accurate calculation of the taxes you’ve paid. When you file your tax return, your main goal is to figure out how much you owe the federal government or how much the federal government owes you if you’re entitled to a tax refund. It’s also important to have a firm grasp on how much of your taxable income truly went toward your taxes throughout the year or how much you need to pay when filing your tax return.
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Effective Tax Rate Definition
When you break down your income and calculate exactly how much is being taxed at different rates, you’re calculating your effective tax rate. It’s the average percentage of the tax rate you pay in federal income taxes.
The Internal Revenue Service (IRS) has seven different tax brackets and the one you fall into is determined by how much income you earned throughout the year. While this may seem like a simple and straightforward way to calculate your taxes, it’s not actually accurate.
The federal government uses a progressive tax system, which means it taxes a higher percentage of income for taxpayers who have earned more. Therefore, not all the dollars you earned throughout the year are taxed at the same rate. Effective tax rate takes this into account.
Adjustments are an important part of your tax return because they can reduce your tax liability. It’s important to understand what adjustments you qualify for so you can claim them and reduce the amount of taxes you owe. There are several types of adjustments offered by the federal government, including the following:
- Contributions you made to a health savings account (HSA);
- Student loan interest you paid;
- Health insurance premiums you paid as a self-employed taxpayer;
- Contributions you made to a retirement plan as a self-employed taxpayer;
- Expenses for educational materials you had as a teacher.
You can choose to accept the standard federal income deduction. In 2019, the standard deduction for a married couple filing jointly was $24,400. For single filers or those married but filing separately, the standard deduction was $12,200 and head of household filers had a standard deduction of $18,350.
If you think the eligible deductions for the year will add up to more than your standard deduction, you can itemize these deductions on your return. Deductions that apply to your tax return are another aspect to take into consideration when calculating your effective tax rate. These deductions also reduce your tax liability and may include the following:
- Mortgage interest you paid on your home loan;
- Charitable contributions;
- Property taxes you paid to your county;
- State income taxes you had to pay.
Tax credits are one of the best ways to reduce your tax liability because they provide credit at a dollar-for-dollar rate. When you’re eligible for federal tax credits and you claim them on your return, they can dramatically reduce your effective tax rate. Some of the tax credits you may qualify for include the following:
- American opportunity tax credit;
- Child tax credit;
- Earned income tax credit;
- Senior or disabled resident tax credit.
How Does Effective Tax Rate Work?
Your effective tax rate is important because it’s the average tax rate you’re paying for the year. When you’re calculating your federal income taxes, a portion of your income is taxed at a certain rate while the other portion may be taxed at a different rate. Multiple tax rates can apply to your taxable income when you calculate the taxes you owe.
This can make it complicated to understand how much you’re truly paying in taxes and how the tax rate you’re paying compares to other taxpayers. However, when you calculate your effective tax rate, you’ll gain a better understanding of how the average tax rate you paid compares to the other tax brackets.
Calculating Effective Tax Rate
You can only calculate your effective tax rate after you’ve completed your Form 1040. Note that Line 15 is a calculation of the total taxes you owe or paid and Line 10 is a calculation of your taxable income. To calculate your effective tax rate, divide the total tax you owe or paid by your taxable income.
Keep in mind, this calculation only provides your effective tax rate for your federal income taxes. Local sales taxes, estate taxes, or state income taxes are not included in this figure. However, you can use the same process to calculate the effective tax rate of your local taxes as well.
Example of Effective Tax Rate
You earned $100,000 in taxable income for the year (Line 10). You paid $10,000 in taxes (Line 15). To calculate your effective rate:
$10,000 divided by $100,000 equals 0.1.
Convert your calculation to a percentage and your effective tax rate is 10%.
Marginal vs. Effective Tax Rate
Your marginal tax rate is the highest tax bracket you fall into based on the income you earned throughout the year. While your marginal tax rate gives you an idea of the taxes you paid, it’s not an accurate snapshot. Your taxable income is taxed at different rates due to the federal government’s progressive tax system. You could have only a few dollars taxed at the highest tax rate or the majority of your taxable income.
Your effective tax rate takes into consideration the different tax rates imposed on your taxable income and provides you with the average rate. This gives you a better idea of where you fall within the federal government’s tax rates.
When you know your effective tax rate, you have a good understanding of the average tax rate you paid for the year. While it’s good to know your marginal tax rate and what tax bracket you fall into, it’s not an accurate account of the taxes you paid. Your effective tax rate determines your tax liability more precisely.
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This post was updated February 24, 2020. It was originally published February 24, 2020.