how the effective tax rate works
as noted above the effective tax rate is the average tax rate of a taxpaying entity this includes both individual taxpayers and corporations the effective tax rate is expressed as a percentage the effective tax rate typically refers only to federal income taxes and doesn t take into account any other types of taxes including to determine their overall effective tax rate individuals can add up their total tax burden and divide that by their taxable income this calculation can be useful when trying to compare the effective tax rates of two or more individuals or what a particular individual might pay in taxes if they lived in a high tax vs a low tax state a consideration for many people thinking about relocating in retirement investors may use effective tax rate as a profitability indicator for a company but it can be difficult to determine the reason for year to year fluctuations in the etr effective tax rate vs marginal tax ratethe effective tax rate is a more accurate representation of a person s or corporation s overall tax liability than their marginal tax rate and it is typically lower when considering a marginal versus an effective tax rate bear in mind that the marginal tax rate refers to the highest tax bracket into which their income falls in a graduated or progressive income tax system like the one in the united states income is taxed at differing rates that rise as income hits certain thresholds two individuals or companies with income in the same upper marginal tax bracket may end up with very different effective tax rates depending on how much of their income was in the top bracket federal tax bracketsfederal tax brackets are determined and passed into law these brackets are overseen in the u s by the internal revenue service irs the amount of income and tax filing status determines the tax brackets in which individual taxpayers fall the table below highlights the current tax brackets in the united states example of an effective tax rateimagine for example a graduated tax system where income under 100 000 is taxed at 10 income between 100 000 and 300 000 is taxed at 15 and income over 300 000 is taxed at 25 now consider two individuals who both hit the upper tax bracket of 25 although one had a taxable income of 500 000 while the other had a taxable income of 360 000 both individuals would pay 10 on their first 100 000 of income or 10 000 both would then pay 15 percent on their income between 100 000 and 300 000 or 30 000 15 of 200 000 finally both would also pay 25 on their earnings over the 300 000 threshold for the individual with 360 000 in taxable income that would come to 15 000 25 of 60 000 but for the individual with 500 000 in taxable income the tax would be 50 000 25 of 200 000 their total tax obligations would be 55 000 and 90 000 respectively while both individuals could say they re in the 25 bracket the one with the higher income has an effective tax rate of 18 90 000 in tax divided by 500 000 in income while the other s effective tax rate is 15 3 55 000 divided by 360 000 