Taxpayers don't pay just one percentage rate on all their incomes, at least not at the federal level. The United States uses a progressive tax system. Different portions of income are taxed at different rates.
Calculating your average tax rate tells you the percentage of your income that you're paying overall. And here's a bit of good news: It's never as much as the tax rate you pay on your highest dollar of income.
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The Progressive Tax System
A progressive tax system is set up in increments. Your overall income is divided into segments, and you pay a different percentage in taxes on each of those segments. The more you earn, the higher the percentage rate becomes.
For example, you'll pay 10 percent on the first $9,875 you earn if you're single in 2020. You'll pay 12 percent from there up to earnings of $40,125, and then 22 percent on income up to $85,525. You're not paying 22 percent on all your income, even though this is commonly said to be your "tax bracket" because it represents your highest rate.
Average Rate vs. Marginal Rate
The term "marginal tax rate" refers to that highest tax bracket. It's how much you'd pay on the extra money if you experience an unforeseen windfall. Your marginal tax rate would be 22 percent if your existing income is $80,000 and someone kindly hands you $5,000 that you don't have to repay. This represents a total income of $85,000, which still comes in at under $85,525, which is where the next highest 24-percent tax bracket begins.
You would not have to give the IRS 22 percent of $85,000, however; you'd just pay that rate for the portion of your income over $40,125. You'd pay your average tax rate on your total income.
The Average Tax Rate Formula
Your average tax rate on that $85,000 – including the bonus $5,000 – works out to 17 percent, not 22 percent.
You'd pay $987, or 10 percent, on your first $9,875 in income; $3,630, or 12 percent, on your income above that threshold up to $40,125; and $9,872, or 22 percent, on your income over $40,125. Add the numbers together and your total tax bill works out to $14,489. Your average tax rate is that number divided by your total income – $85,000 in this example – and $14,489 divided by $85,000 is 17 percent.
The average tax rate equation begins with figuring out the percentage you pay on each increment of your income, then adding the numbers up and dividing the total by your income. This is the true reflection of what you pay in taxes.
Other Tax Variables
Another important consideration is that you're not going to be paying taxes on that entire $85,000.
First, you're either going to itemize your deductions or claim the standard deduction for your filing status. The standard deduction for a single filer is $12,400 in 2020, so you can scrape that amount off of $85,000, and you're down to $72,600.
Now your total tax paid is only $11,762: $987 plus $3,630 plus $7,145 on those dollars over $40,125. Divide that by $72,600, and your average tax rate drops to 16 percent. That might still make you wince, but it's better than your 22-percent marginal rate.
And if you're eligible for a tax credit, too, this further changes the numbers. Credits come directly off what you owe the IRS, just as though you had made a payment. Maybe your total tax bill was $11,762 but you're eligible to claim a $1,000 credit. Your tax bill then drops to $10,762, and your average tax rate falls to just 14 percent: $10,762 divided by $72,600.
Every penny and percentage point counts.