When a client asks how much they actually paid in taxes in a given year, they’re looking for their effective tax rate. The effective tax rate is the actual tax obligation when everything is said and done. This rate takes into account deductions, distributions, credits, etc. The effective tax rate is simply the client’s total taxes paid, divided by taxable income. The marginal tax rate is the amount of tax applied to the next dollar earned. As income increases you may find yourself bumped into a higher marginal bracket. When evaluating strategies and making financial planned decisions, the marginal tax rate is the correct one to use. IRA conversions and distributions are always taxed at the marginal rate; therefore it is important to plan accordingly when making financial decisions.
Effective Rate Example:
Assume a couple earns $250,000 during the tax year. They are in the 33% marginal tax bracket. However, the income falls across the 10%, 15%, 25% and 28% tax brackets. Depending on various deductions, their effective tax rate will most likely be between 15%-20%, perhaps even lower.
Marginal Rate Example:
If a client plans to be in the 25% tax bracket next year, then taking an IRA withdrawal for $1,000 will incur $250 in taxes. If the client is in the 33% bracket this year, an IRA distribution will result in a tax liability of $330. Distributions are always taxed at the marginal rate. Therefore, by waiting until next year, when the client plans to be in a lower marginal bracket, they will see tax savings of $80.