Question: What is the difference between marginal and effective tax rates, and which is more important?
Answer: The most straightforward way to think of the difference is that your marginal tax rate applies only to the last dollars you make over the course of the tax year while the effective tax rate represents the average rate you pay on all the money you make during the year.
The reason these two rates vary has to do with the progressive nature of our federal income tax system. Rather than tax everyone at the same rate -- a so-called flat tax -- the tax code uses a tiered system in which income up to a certain level is taxed at one rate and income beyond that level is taxed at a higher rate up to a certain level, at which a still-higher rate is applied, and so on. The top rate at which any of a taxpayer's income is taxed is considered his or her marginal tax rate, whereas the average rate the taxpayer pays across all that income is considered his or her effective tax rate.
Calculating the difference
To illustrate how marginal and effective tax rates differ, let's first look at the federal tax brackets for the 2015 tax year. (Provincial tax is extra and varies by province but works on the same principle, with the exception of Alberta which has a flat 10% provincial tax.)
| Federal tax rates for 2015 | ||
| Taxable income | Tax rate | |
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| On the first $44,701 | 15% | |
| On the portion over $44,701 up to $89,401 | 22% | |
| On the portion over $89,401 up to $138,586 | 26% | |
| On income over $138,586 | 29% | |
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| Source: Canada Revenue Agency | ||
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Using the above tax brackets, let's look at how marginal and effective rates come into play. For our example, we'll use a taxpayer with $95,000 in taxable income. Here's how that $95,000 would break down in terms of the applicable federal tax brackets:
| Example of marginal and effective tax rates | |||
| Taxable income between | Rate | Tax owed | |
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| $0 - $44,701 | 15% | $6,705.15 | |
| $44,701 - $89,401 | 22% | $9,834.00 | |
| $89,401 - $95,000 | 26% | $1,455.74 | |
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| Total federal tax owed: | $17,994.89 | ||
| Effective (average) tax rate: | 18.94% | ||
| Marginal (top) tax rate: | 26% | ||
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| Source: CRA and Morningstar | |||
As you can see, the taxpayer's marginal tax rate -- what she pays at the top end of her taxable income -- differs quite a bit from what she pays as an overall average on her income. So, why do we hear so much about marginal income tax rates when effective income tax rates are arguably more important?
There are a few reasons. For one, political debates over income taxes often center on marginal rates, especially for upper-income taxpayers (the top federal rate of 29% currently applies to income above $138,586, while at the provincial level the top bracket is for Ontario residents with income above $220,000, with a marginal rate of 13.16%).
When marginal rates matter
However, the more important reason is that marginal rates come into play when making certain tax-management decisions. For example, let's say a taxpayer is considering whether to contribute to an RRSP, in which contributions are tax deductible, or a TFSA, in which contributions are not deductible but where income and capital growth are tax-free. Since a contribution to an RRSP lowers the investor's overall taxable income, the deduction is typically calculated based on the investor's marginal tax rate -- that is, the rate paid on his or her last dollar of taxable income for the year. If the investor contributes $5,000 to an RRSP for the year and falls in the 22% marginal tax bracket, the deduction on the contribution can be said to be worth a tax savings of $1,100 at the federal level ($5,000 times 0.22).
Conventional wisdom says that if we expect our marginal rate to go down in retirement, the RRSP account is preferable, while if we expect it to go up, the TFSA is better. Of course that's a very simplified rule of thumb, and for most Canadians the reality is a bit more complex, as discussed in this article.
Marginal tax rates also play a role when considering other types of tax breaks as well. Deductions that reduce the taxpayer's taxable income -- such as medical expenses and moving expenses -- represent a savings applied against the marginal rate. So, for someone with a marginal tax rate of 26% who claimed $6,000 in moving expenses last year, that deduction is worth $1,560 ($6,000 times 0.26). With enough deductions, that taxpayer could even fall into a lower marginal tax bracket.
Figuring out your effective and marginal rates
While the marginal tax rate focuses on what happens at the top of your taxable income amount, it's your effective tax rate that is typically more meaningful. After all, it's what you pay on all of your income combined that matters, not just the portion near the top.
To calculate your effective federal income tax rate, look at line 420 of your T1 General form to find your net federal tax. Divide this amount by your taxable income, found on line 260. Multiply the number by 100, and you get your effective tax rate. To calculate you total (federal and provincial) effective tax rate, use line 435 instead of 420 on your T1 General.
The above method looks at your tax rate on income after deductions and tax credits are applied; but if you wanted to use your income before these are taken out, you could instead use your net income, found on line 150 of the T1 General.
To figure out your marginal federal income tax rate, use the table at the top of this article to see where your taxable income falls within the brackets.
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