Understanding marginal vs. effective tax rates

And which one you should pay more attention to.

Adam Zoll 22 June, 2015 | 5:00PM

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.

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Adam Zoll

Adam Zoll  Adam Zoll is an assistant site editor with Morningstar.com

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