Effective Tax Rate

http://www.cpa-cfa.org

Effective Tax Rate Formula

Effective tax rate = total taxed paid ÷ taxable income

Effective Tax Rate Definition

The US taxes corporations and individuals on a progressive or marginal basis – meaning one pays different tax
rates for different income amounts. US Tax Bracket 2010

Essentially, the effective tax rate illustrates if taxes were applied at a constant or flat rate.

Your effective tax rate will always be lower than your marginal tax rate due to the taxes paid on portions of
your income at the lower marginal tax brackets.

Reducing Your Effective Tax Rate

After reading this, you may ask “How do I reduce my effective tax rate” – below are a couple of ways to
increase your tax deductions and tax credits which thereby reduce your taxable income.
- Contributions to a traditional 401K
- Charitable contributions
- Mortgage interest
- Recognize losses on investments ($3000 loss allowed per year with remaining loss carried forward)
- Using flex spending accounts for medical expenses (I don’t use them but many people do)

Difference between Effective and Marginal Tax Rates

Whether it’s at a dinner party or on Capitol Hill, people usually cite marginal tax rates. So an individual
making over $200,000 a year would be marginally taxed at 33%. However, that 33% tax rate is only applied to
a portion of an individual’s income. As we learned above, the individual effectively pays less in taxes. And for
those individuals who have intelligent tax advisers or are tax efficient, they can pay very little in taxes.

In 2010, the IRS released an analysis of the 400 richest American tax filers. There are a number of interesting
facts found in the analysis but the most interesting are the effective tax rates. Of the 400 richest American tax
filers, which collectively earned $138 billion in 2007, 66% or 264 of them had an effective tax rate between
10% and 20%. And 6% or 25 of the richest filers in the United States had a federal effective tax rate between
0% and 10%!

Not here to get political. Just using this as an example to illustrate the difference between marginal and
effective tax rate – which is big!

US Tax Bracket: http://www.irs.gov/app/understandingTaxes/whys/thm03/les03/ac1_thm03_les03.jsp

Analysis: http://www.irs.gov/pub/irs-soi/07intop400.pdf