Understanding Marginal Versus Effective Tax Rates And When to Use Each


Confused by the U.S. tax code? You’re not alone. Figuring out deductions, credits, and exemptions rank as some of the most complicated aspects of understanding taxes. 

Today, we are going to focus on marginal and effective tax rates — and how you can benefit from understanding the differences between them.

But before getting into the details, it’s important to note that the U.S. federal income tax system is progressive. This means tax rates are increasing in tandem with earnings growth.

So what’s the difference between the effective tax rate and marginal tax rates?

The effective tax rate is the average amount of taxes on your earnings. It’s a very straightforward calculation. To determine your effective tax rate, take Line 10 on the 2018 IRS Form 1040 “Total Tax” and then divide it by your “Taxable Income” on Line 15. The result is your effective tax rate (or blended tax rate)— which, by the way, excludes any other taxes you might pay (like property, state or sales taxes). 

Your marginal tax rate is the top tax rate you’ll pay on each additional dollar earned. To provide an example, if you’re single and with taxable income of $160,725, your marginal rate is 24%. However, if you earn just $1 more, that additional dollar is now taxed at your new marginal rate of 32%. Knowing your marginal rate is extremely important, especially when trying to manage your taxes and income.

For the 2019 tax year, the marginal tax rates are 10%, 12%, 22%, 24%, 32%, 35% and 37%. These are unchanged from the 2018 tax year.


Before 2018, the seven tax brackets were higher; 0%, 15%, 25%, 28%, 33%, 35%, 39.6%, respectively. The 2017 Tax Cut and Jobs Act reduced the marginal tax rates to their current levels. However, they are currently slated to sunset after 2025. Whether this will actually happen is anyone’s guess.

There is new change that will affect marginal rates going forward. Until now, the Consumer Price Index (CPI) has been the method of choice for adjusting marginal rates for inflation. The CPI measures the average change over time in the prices paid by consumers for commonly-purchased goods.

Starting with the 2019 tax year, marginal-rate inflation adjustments will use a “chained CPI” formula. This new method captures a larger variety of different consumer goods than the basic CPI. 

As with any change, this has both supporters and critics. Those who support the new chained-CPI formula believe it is more accurate. Meanwhile, critics say the new formula is akin to a hidden tax that will grow over time.

Whether you support it or not, the chained-CPI formula will reduce the amount of inflation adjustments to marginal rates each year. What does this mean for you? If your earned income rises faster than the rate of inflation, you could be bumped up into the next marginal tax bracket. 

Why do I need to think about marginal tax rates?

For many individuals and families, taxes represent one of the largest annual expenditures - directly impacting your wealth.

Let’s say you’re trying to decide whether contributing to a pre-tax or after-tax account is best for you.

An often-quoted retirement-planning rule of thumb is that if you expect your marginal tax rate to decrease in your golden years, funding a pre-tax account now is likely the best course of action. In other words, if your marginal rate is higher now in your working years, make the pre-tax contributions today and defer paying those taxes to a later date at lower tax rates. 

Conversely, if you expect your marginal rate to increase in retirement, you’re better off contributing to a Roth IRA and paying the lower tax rates today. While no one has a crystal ball, it’s not a stretch to think that tax rates will be higher down the road. True, you won’t save money in taxes NOW by contributing to a Roth IRA. But your withdrawals from these accounts in retirement will be tax-free, providing tax liquidity in the future. With the Tax Cuts and Jobs Act slashing marginal rates across the board you may benefit in the long-run by funding certain after-tax accounts versus the traditional pre-tax accounts.

Managing your taxable income is particularly important when in retirement. If all of your retirement savings is in tax-deferred accounts, you could be bumped into a higher marginal tax bracket when you take your annual required minimum distribution (age 70 1/2) or need to draw additional funds for spending needs. By having Roth assets you can draw funds for those spending needs tax-free (tax liquidity). But if you have to draw from a tax-deferred account you not only have to pay taxes on the funds at your higher marginal rate, but it could also subject you to additional taxes. By increasing your income it could increase the taxable portion of your Social Security benefits. It can also subject you to higher Medicare Part B and Part D premiums if your income breaks a certain level. All this equals less money in your pocket. 

Roth conversions can prevent you from being stuck with just pre-tax savings when retired and provide tax liquidity in the future. A conversion allows you to move pre-tax Traditional IRA assets into tax-free Roth. Of course, you’ll have to pay taxes in the year of your conversion, but this doesn’t have to be overly painful. Remember, timing is everything. Consider a Roth conversion:

  • In years when your income is lower than usual (due to a job change or when you retire and earned income drops)

  • After a big drop in the value of your pre-tax IRA (bear markets aren’t ALWAYS a bad thing)

  • Over a period of years (to reduce the sting of a big tax bill in a single year)

Retiring with assets in both pre-tax and after-tax accounts? Consider keeping pre-tax withdrawals low to avoid a bump in your marginal bracket. Then withdraw from your post-tax accounts to fill in any gaps.