What is Average Tax Rate? What is Effective Tax Rate? Do Either Matter?

What is average tax rate? What is effective tax rate? Which matters most when it comes to making investments?

I recently received an email from “S”. He is a friendly reader asking about how his effective tax rate might impact the investments he was considering. Here’s what he wrote:

I am trying to figure out my effective tax rate on income in order to estimate a retirement nest egg using tax-deferred retirement savings plans. I have read so many different methods to figure this rate and I don’t know which method is accurate.

“S” is asking me about effective tax rate, but he might be actually thinking about average tax rate. Based on what he wrote, we just don’t know. The reason is that the term “effective tax rate” relates to both “average tax rates” and “marginal tax rates”. That’s why “S” can’t find one definition for the term. But “S” brings up a very important topic. Let’s dive in.

What is average tax rate?

Your average tax rate is the total tax you pay divided by your income. So if you earned $50,000 and you paid a total of $10,000 in taxes, your average tax rate is 20%.

Now, lets’ say you know your average tax rate. What can you do with that information? Not a thing. This data is not helpful to you in any way. And if “S” calculates his own average tax rate – or effective average tax rate – he won’t be able to make a better decision about how to invest for retirement income.

Now, let’s take a look at the effective marginal tax bracket. This is the tax Uncle Sam will levy on you if you make one more taxable dollar. As you know, we have a progressive tax system right now (see below). The more you make the higher your tax rate climbs.

Assume you make $50,000 and you are in the 30% marginal tax bracket. If you make one more taxable dollar you get to keep 70 cents and the government gets to take 30 cents. That’s information you and “S” can use.

How?

Remember that our reader wants to decide how to invest. Let’s just assume that he has Social Security, pensions and rental income that comes up to $50,000. If his effective marginal tax bracket is 30%, he knows that if he takes a dollar out of his retirement account, he’ll keep 70% of it. If instead he takes a dollar out of a non-retirement account, he’ll keep all of it. (Of course all the earnings on the non-qualified account are taxable whether or not he makes a withdrawal.)

So knowing your marginal tax rate or effective marginal tax rate helps you invest smarter. Knowing your average tax rate doesn’t help you do a thing.

How should you calculate the effective marginal tax rate?

There are various opinions on this as well but if you think about how you are going to use the information, the answer presents itself. We want to figure out how much money we’ll keep if we earn one more taxable dollar. That being the case, the only income you care about is taxable income. And you don’t have to do any calculation to determine your marginal tax bracket. You just have to look it up. Here’s a sneak peak at the marginal tax brackets for 2014 (the rates you’ll have to be concerned with when you file your 2014 taxes in 2015).

So if you want to know how to invest from a tax standpoint, figure out what your net taxable income is for the year and use the table above to determine what your marginal tax bracket will be. Not too complicated and practical. Just the way I like it.

Do you find it useful to know your average tax rate? How?