The percentage of a person’s or company’s income that they owe or pay in taxes is called their “effective tax rate.” The average rate at which a person’s earned income, like salary, and unearned income, like stock profits, are taxed is the effective tax rate. The effective tax rate for a company is the average rate at which its pre-tax gains are taxed, while the statutory tax rate is the legal number set by law.
KEY TAKEAWAYS
- The effective tax rate is the amount of a person’s net income that goes toward taxes.
- The effective corporate tax rate is the amount that companies pay on their income before taxes.
- Most of the time, the “effective tax rate” only refers to the federal income tax.
- The effective tax rate can be used to figure out how much a person or a business has to pay in taxes.
- Under marginal tax rates, each person is taxed at a different rate that goes up when their income hits certain limits.
How to Figure Out the Real Tax Rate
When written out as figures, the actual tax rates for both people and businesses look like this:
For a single person, ETR = Total Tax Taxable Income. For a business, ETR = Total Tax Earnings Before Taxes.
So, here’s how to figure out what your actual tax rate is:
A person can figure out their effective tax rate by looking at their Form 1040 and reducing the total tax amount, which is on line 24, by the amount of taxable income, which is on line 15, and then increasing the result by 100.
For businesses, the effective tax rate is found by dividing the total tax costs by the company’s profits before taxes. As was said above, an entity’s effective tax rate is its average tax rate. This is true for both individuals and businesses that pay taxes. The real tax rate is given as a number.
Most of the time, the effective tax rate only refers to federal income taxes. It doesn’t take into account any other taxes, such as:
- State and local tax on income
- Sales taxes
- Taxes on property
- Other types of taxes a person might have to pay
People can figure out their effective tax rate by adding up all of their taxes and dividing that number by their gross income. This figure can be helpful if you want to compare the effective tax rates of two or more people, or if you want to know how much a certain person would pay in taxes if they lived in a high-tax state vs. a low-tax state. This is something that many retirees think about when they are thinking about moving.
Investors may look at the effective tax rate (ETR) to see how profitable a company is, but it can be hard to figure out why the ETR changes from year to year.
Marginal tax rate vs. effective tax rate
The effective tax rate is a more true way to show how much a person or company owes in taxes total than the marginal tax rate, and it is usually lower. When deciding between a marginal tax rate and an effective tax rate, keep in mind that a person’s highest tax level is where their marginal tax rate is.
In a graduated or progressive income tax system, like the one in the United States, income is taxed at different rates that go up as income hits certain levels. Depending on how much of their income was in the top tax bracket, two people or businesses with the same amount of income in the top tax bracket may end up with very different effective tax rates.
The Federal Tax Bands
The federal tax rates are set and made a part of the law. In the United States, the Internal Revenue Service (IRS) is in charge of these rates. Each taxpayer’s tax rate is based on how much money they make and how they file their taxes.
One Example of a Real Tax Rate
Imagine, for example, that the tax rate on income under $100,000 is 10%, the tax rate on income between $100,000 and $300,000 is 15%, and the tax rate on income over $300,000 is 25%. Now, think about two people who both hit the top tax rate of 25%, but one had a taxable income of $500,000 and the other of $360,000.
Both people would pay 10%, or $10,000, on their first $100,000 in income. Then, both would have to pay 15% of their income between $100,000 and $300,000, which is $30,000 (15 percent of $200,000).
Lastly, if either of them made more than $300,000, they would pay an extra 25% tax on that amount. For a person with a taxed income of $360,000, that would be $15,000 (25% of $60,000). But the tax for the person with a taxable income of $500,000 would be $50,000 (25% of $200,000). The total amount of taxes they would have to pay would be $55,000 and $90,000.
Even though both people are in the 25% tax band, the one with the higher income has an effective tax rate of 18% ($90,000 in taxes divided by $500,000 in income) and the other has an effective tax rate of 15.3% ($55,000 divided by $360,000).
How do I figure out what my real tax rate is?
As an individual worker, it’s easy to figure out your actual tax rate. Divide your total tax by the amount of your pay that is taxed. Multiply by 100 to get the rate. On Form 1040, line 24 shows how much tax you owe, and line 15 shows how much of your income is taxed.
How is the Effective Tax Rate different from the Marginal Tax Rate?
The average tax rate for a person or a business is the effective tax rate. As such, it is the share of the taxpayer’s annual income that goes to taxes. On the other hand, a marginal tax rate is the total amount of tax that is paid on different levels of income. This means that the tax rate goes up as a person’s income goes up. In marginal tax systems, the first level of income is taxed at a lower rate. This is called a tax band. If you make more than that, you have to pay a higher rate.
Which rate is lower: the effective tax rate or the marginal tax rate?
The effective tax rate for a person is less than the highest tax rate. This is because your salary is split into different amounts by the highest tax rate. The tax rate on the first level of income is lower, while the tax rate on higher levels of income is higher. Taxes are based on values in between for numbers that fall in the middle.
In conclusion
The amount of tax you owe on your taxable income is your effective tax rate. This is because of how the IRS sets up and keeps track of tax levels. On Form 1040, you can easily figure out your effective tax rate by dividing your total tax by the amount of your taxable income. The effective tax rate for a company is found by dividing the total tax by the company’s profits before interest. If you don’t know how to do something connected to your taxes, you should talk to a tax expert or other professional who can point you in the right way.
