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Effective tax rate vs Marginal tax rate: What's the Difference?

When it comes to taxes, there are two key terms that are often used interchangeably but have very different meanings: effective tax rate and marginal tax rate. While both effective and marginal tax rates are important to understand, they are not the same thing. Here's a look at the key difference between effective tax rate and marginal tax rate.

What is Effective Tax Rate?

Your effective tax rate is the average rate at which your income is taxed. To calculate your effective tax rate, simply take your total tax liability for the year and divide it by your total income. For example, let's say you have a total income of $50,000 and a total tax liability of $5,000. Your effective tax rate would be 10% ($5,000/$50,000).

What is Marginal Tax Rate?

Your marginal tax rate is the rate you pay on your last dollar of income. In other words, it's the tax rate you pay on the portion of your income that is taxed at a higher rate. For example, let's say you have a total income of $50,000 and a marginal tax rate of 25%. This means that your last dollar of income is taxed at a rate of 25%.

Why Effective Tax Rate is Important

Your effective tax rate is important because it gives you an idea of the overall tax burden you are shouldering. It's a good measure of how much of your income is going towards taxes. Additionally, your effective tax rate can be a useful tool for comparing your tax burden to others in your same tax bracket.

Why Marginal Tax Rate is Important

Your marginal tax rate is important because it determines the rate at which your next dollar of income will be taxed. In other words, it tells you the tax rate you'll pay on any additional income you earn. For example, let's say you have a marginal tax rate of 25%. This means that if you earn an additional $1,000 of income, you'll owe $250 in taxes on that income (25% x $1,000).

How Effective Tax Rate and Marginal Tax Rate Affect Your Taxes

While effective tax rate and marginal tax rate are two different things, they are both important factors that affect your overall tax liability. Effective tax rate is a good measure of the overall tax burden you are shouldering, while marginal tax rate tells you the tax rate you'll pay on any additional income you earn. Understanding both of these rates can help you make informed decisions about your taxes and ensure that you are paying the right amount of tax.

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