Effective Tax Rate: How To Calculate The Amount Of Taxes You Really Pay

Your tax bracket is not the same as how much you pay.

It’s safe to say that many Americans are a bit fuzzy on how taxes work and how much they actually pay.

A 2018 Gallup poll, for instance, found that 45% of respondents said they believe they pay too much in federal income taxes. Interestingly, however, approximately 47% of Americans don’t pay any federal income taxes.

You probably do know that the more money you earn, the higher the rate at which you are taxed. That’s because the U.S. follows a progressive tax system, in which different levels of income correspond to tax brackets of various rates. According to 2021 brackets, current income tax rates are 10%, 12%, 22%, 24%, 32%, 35% and 37%.

However, you might not realize that the tax bracket you fall in is not actually the rate you pay in taxes. In fact, you probably pay quite a bit less.

Seem confusing? Don’t worry, it’s not as complicated as it sounds. To know how much you really pay in income taxes, you need to calculate your effective tax rate. Here’s how.

How To Calculate Your Effective Tax Rate

Since we follow a progressive tax system, different portions of your income are taxed at different rates. This is meant to ensure that the lowest-earning Americans aren’t forced to pay the same tax rate as higher earners.

For example, 2021 tax brackets for single filers are as follows:

  • 10%: Up to $9,950
  • 12%: Income of $9,951 to $40,525
  • 22%: Income of $40,526 to $86,375
  • 24%: Income of $86,376 to $164,925
  • 32%: Income of $164,926 to $209,425
  • 35%: Income of $209,426 to $523,600
  • 37%: Income over $523,600

So what does this mean, exactly?

Let’s say you’re a single filer earning $87,000 per year in total gross income. Once you subtract tax deductions, contributions to a retirement account and any other adjustments, you end up with an adjusted gross income (AGI) of $70,000.

That means you fall into the 22% tax bracket. This is known as your marginal tax rate, or the amount of tax you pay on the last dollar you earned. But you don’t actually pay 22% in taxes on all your earnings.

Instead, the first $9,950 of income is taxed at 10%. The next $9,951 to $40,525 of income is taxed at 12%. The last $29,425 of your income (income above $40,525) is what would be taxed at the highest rate of 22%.

Add up all those tax amounts ($995 + $3,669 + $6,473.50), and you end up with a total tax liability of $11,137.50. If you then divide that number by your total taxable income, you get 15.9%. That’s your effective tax rate, or the average amount of tax you pay on the entirety of your taxable income for the year.

Let’s look at another example. This time you are married and file jointly with your spouse. These are the tax brackets for married taxpayers filing jointly as of 2021:

  • 10%: Up to $19,750
  • 12%: Income of $19,751 to $80,250
  • 22%: Income of $80,251 to $171,050
  • 24%: Income of $171,051 to $326,600
  • 32%: Income of $326,601 to $414,700
  • 35%: Income of $414,701 to $622,050
  • 37%: Income over $622,050

Say your spouse’s AGI for the year is $110,000, bringing your combined taxable income to $180,000. This would put you in the 24% tax bracket (aka, your marginal tax rate).

Here’s how your effective tax rate is calculated: The first $19,750 of income is taxed at 10%, the next $60,500 is taxed at 12%, the next $90,800 is taxed at 22% and the last $8,950 is taxed at 24%.

Add that all up ($1,975 + $7,260 + $19,976 + $2,148) and you pay a total of $31,359 in income taxes. Divide by your total income of $180,000 and your effective tax rate is 17.4%.

“The reason the effective tax rate is important is because it can enable you to compare different tax planning strategies and see which one is going to enable you to optimize your taxes,” said Ryan McInnis, founder of Picnic Tax.

For some people, calculating their effective tax rate is pretty straightforward because they only earn a salary, he said. “However, if your income streams are a little more diverse and you have lots of deductions, the math can get complicated.”

For that reason, it can be a good idea to work with an accountant who can help you find all the deductions you qualify for and lower your taxable income as much as possible. That can be especially helpful if you’re teetering between two tax brackets and can save some money by staying in the lower one.

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