Tax Rate vs. Marginal Tax Rate

Your income tax return won't tell you your average tax rate or marginal tax rate.

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If you ask people about their tax rates, many people respond with their marginal tax rate, which is the highest tax bracket that they fall in for the year. However, because you don't pay that tax rate on all of your income, your overall or "average" tax rate is usually significantly lower. your highest tax rate applies only to higher levels of income.

Average Tax Rate

Your average tax rate equals your tax liability divided by your gross income before you take any deductions. For example, if you have $70,000 of income and you pay $8,400 in income taxes, your average tax rate equals 12 percent. This figure tells you, on average, how much of every dollar went to income taxes, which helps you budget for future years.The drawback to the average tax rate is that it doesn't give you a sense of how much your income tax bill will change if your income were to increase or decrease.

Marginal Tax Rate Defined

Your marginal tax rate refers to the highest tax rate you pay. For example, say you have $70,000 in income but you're eligible to claim $9,000 in deductions, which brings your total taxable income down to $61,000. If the 22 percent tax bracket for your filing status includes income from $57,000 to $70,000, 22 percent is your marginal rate. That's the highest tax rate you pay, but you pay that rate only for your income that was in excess of $56,999.

Marginal Tax Rate Uses

The marginal tax rate is most useful for determining how changes in your taxable income would alter your tax liability. For example, if you are in the middle of the 27 percent tax bracket, an additional $100 deduction would save you $27 in taxes; an extra $100 of taxable income would increase your tax liability by $27. You can use this information to make decisions about the true cost of making a charitable contribution or how much working more will add to your income after taxes.

Long-Term Capital Gains

Long-term capital gains income, which is the profit from selling most assets you've held for at least one year, is taxed at lower income tax rates than ordinary income. As of 2012, if you are in the 25 percent tax bracket or higher, you pay only 15 percent. If you are in a lower tax bracket, you don't pay any capital gains tax. For example, if you fall in the 35 percent tax bracket and sell stock you've held for more than a year for a profit of $20,000, that income is taxed at the 15 percent long-term capital gains rate.

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About the Author

Mark Kennan is a writer based in the Kansas City area, specializing in personal finance and business topics. He has been writing since 2009 and has been published by "Quicken," "TurboTax," and "The Motley Fool."

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