Tax Planning: Marginal vs. Effective Taxes

The United States operates on a progressive tax system. Instead of applying one flat tax rate to all income, the system uses seven tax brackets, meaning different portions of income are taxed at different rates.

A marginal tax rate is the percentage of tax you pay on each additional dollar of taxable income. In other words, it’s the rate that applies to your next (or last) dollar earned.

An effective tax rate is the average percentage of income that a person or business pays in taxes over a specific period. It reflects the overall tax burden, not just the rate applied to the highest tax bracket.

Let’s use an example with 2026 federal tax rates to demonstrate the difference.

Example 1: Tom is a 35-year-old single taxpayer who earns $150,000 in wages. He takes the standard deduction of $16,100 while filing taxes, resulting in taxable income of $133,900 ($150,000 − $16,100). His income is taxed across multiple brackets as follows:

Tom’s marginal tax rate is 24%, because that is the bracket in which his last dollar of income was taxed.

Tom’s effective tax rate is 16.5%, which represents the average tax paid on his total $150,000 of income ($24,734 in taxes ÷ $150,000 income).

Now let’s look at a second example involving joint filers.

Example 2: Jennifer and Derek are both 40 years old and collectively earn $225,000 in wages. They take the standard deduction of $32,200, so their taxable income is $192,800 ($225,000 − $32,200). Their income is taxed as follows:

Jennifer and Derek’s marginal tax rate is 22%, because their last dollar of income falls within that bracket.

Their effective tax rate is 14.2%, reflecting the average tax paid on their total household income ($31,840 in taxes ÷ $225,000 income).

Understanding the difference between marginal and effective tax rates is important when making financial decisions during both the accumulation phase (working years) and decumulation phase (retirement). Thoughtful tax planning can help individuals and families better manage their overall tax burden and align financial decisions with long-term goals. Your financial advisor is also a resource to assist you in navigating these tax concepts and outlining potential tax planning strategies tailored to your overall financial picture.

This article is for informational purposes only and does not constitute tax advice. Please consult your tax advisor or accountant regarding your specific situation.