Understanding Marginal Versus Effective Tax Rates
As a young CPA, I had tremendous difficulty grasping the difference between a taxpayer’s “effective” tax rate and his “marginal” tax rate. Of course, I also have tremendousdifficulty grasping how Twitterworks,so perhaps I’m not the best barometer for this sort of thing.
But if you find yourself similarly challenged, thispiece from the USA Today may help end the confusion. The impetus for the articleis therecent hubbub surrounding Republican Presidential candidate Mitt Romney’s admission that he paid a tax rate of approximately 15% on his millions of taxable income. As the author points out:
Under the United States’ progressive tax system, income is taxed at graduated rates. An individual’s tax bracket, sometimes referred to as the marginal tax rate, refers to the percentage of income that’s taxed at the top tax rate — not the rate for the entire amount. (Ed note: this marginal rate is often referred to as the tax rate imposed on the last dollar of taxable income earned.) The effective tax rate, meanwhile, is the amount a taxpayer pays in taxes as a percentage of total income.
Thus, assume Romney earned $500,000 in speaking fees and $5,000,000 in long-term capital gains from his role as a retired partner in Bain Capital. While Romney’s marginal tax rate would be 35%, as his income level reaches the highest tax bracket, the fact that the overwhelming majority of his taxable income qualifies for the preferential tax rate on capital gain means his effective tax rate would approximate 15%.
