Marginal and effective tax rates

0:00- [Instructor] So let's talk a little bit about marginal and effective tax rates, and this is something that I see a lot of people get confused about, so please pay attention. And sometimes, even people mislead other people based on marginal and effective tax rates.

0:15So in a previous video, we worked through a scenario where if someone made $60,000 in gross income, and let's just assume they weren't making any contributions to 401(k)s or IRAs pre-tax, they would have the same adjusted gross income. They are filing as a single person, so they have a $15,000 standard deduction, so their taxable income, 60,000 minus 15,000 was 45,000.

0:39And we saw how the tax brackets work. That first 11,925 is taxed at a 10% rate, and then the remaining amount above and beyond 11,925 was taxed at 12%, and we figured out that was 3,969. And when you subtracted both of these amounts for federal taxes from the original $60,000, this person had a take home pay of 54,839.

1:08So what's the difference between marginal and effective rate? So the marginal rate, when people say the word marginal, they're saying for every incremental dollar or incremental anything, that's usually talking about on the margin, on the boundary. So in this situation, the marginal tax rate is 12%.

1:27If this person were to make an extra dollar, that extra dollar, until they crossed this 48,475 taxable income threshold, that incremental dollar is going to be taxed at 12%. Now, once their taxable income crosses 48,475, each incremental dollar is going to be taxed at 22%.

1:49So imagine someone had taxable income of $50,000. Their marginal tax rate would be 22%, but that doesn't mean they're paying 22% on all of that $50,000. It's just 22% on the increment above 48,475. And so a lot of times, people are talking about effective tax rates, but they're using the marginal tax rate to say, "Oh, you're in that tax bracket.

2:17You're paying 22% on all your money." That is inaccurate. You're only paying 22% on the increment above 48,475 and below 103,350. And just to make this clear, that scenario that I did in our previous video, this person with $60,000 of gross income and $45,000 of taxable income, their marginal tax rate is 12%, but what is their effective tax rate?

2:44Well, we could get our calculator out. We take the total amount of taxes paid, so 1,192.50 plus 3,969 is equal to that, $5,161.50, and then we wanna divide by the taxable income because this is what you're applying the taxes to, not the gross income. So if we divide that by $45,000, we are going to get the effective tax rate, which is 11.47%.