Q. When should I use marginal tax rate, and when should I use effective tax rate?
A. Most people are confused about the differences between the marginal tax rate and effective tax rate, so don't be too bad about this.
Effective Tax Rate
Effective tax rates are used to measure a person's total tax obligation relative to his/her income; accordingly, it is a useful tool to compare the relative tax obligations among several people.
For example, it's widely reported Warren Buffett's tax rate is lower than and his secretary's tax rate; that refers to his effective tax rate. The effective tax rate is a measure of the portion of one's income that is consumed by one's tax obligations.
It should be noted that this measure is still a relative measure; even if Warren Buffett's effective tax rate is lower than his secretary's, his total tax liability - the total amount of taxes he actually pays - is still far larger.
The fundamental usefulness of effective tax rates is to compare across people and the portion of each person's income that is consumed by taxes. Effective tax rates can also be useful to simply understand the portion of an individual's overall income that is consumed by taxes - for instance, in determining an 'average' tax rate to apply during retirement.
Marginal Tax Rate
Marginal tax rates, on the other hand, are used to measure how a person's tax obligation will change based on some change in strategy; unlike an effective tax rate, which is properly used to compare person A to person B, the marginal tax rate is used to compare strategy / scenario A to strategy / scenario B for a particular person/couple.
The marginal tax rate is used in this manner because it is, by definition, meant to measure at the margin the impact of making a certain change or implementing a certain strategy, by evaluating the tax obligation in scenario A, and scenario B, and the relative difference between the two.
This makes marginal tax rates especially useful in evaluating income deferral or acceleration strategies, from Roth conversions or contributing to an IRA to using a tax-deferred annuity to deciding whether to harvest capital gains or capital losses.
The Bottom Line
The marginal tax rates measure the incremental tax consequences between strategies (scenario A vs scenario B), while effective tax rates measure the relative tax obligations of different people (person A vs person B) or simply a person's total tax obligation relative to income (e.g., to understand how much of their income they keep over time).
A. Most people are confused about the differences between the marginal tax rate and effective tax rate, so don't be too bad about this.
Effective Tax Rate
Effective tax rates are used to measure a person's total tax obligation relative to his/her income; accordingly, it is a useful tool to compare the relative tax obligations among several people.
For example, it's widely reported Warren Buffett's tax rate is lower than and his secretary's tax rate; that refers to his effective tax rate. The effective tax rate is a measure of the portion of one's income that is consumed by one's tax obligations.
It should be noted that this measure is still a relative measure; even if Warren Buffett's effective tax rate is lower than his secretary's, his total tax liability - the total amount of taxes he actually pays - is still far larger.
The fundamental usefulness of effective tax rates is to compare across people and the portion of each person's income that is consumed by taxes. Effective tax rates can also be useful to simply understand the portion of an individual's overall income that is consumed by taxes - for instance, in determining an 'average' tax rate to apply during retirement.
Marginal Tax Rate
Marginal tax rates, on the other hand, are used to measure how a person's tax obligation will change based on some change in strategy; unlike an effective tax rate, which is properly used to compare person A to person B, the marginal tax rate is used to compare strategy / scenario A to strategy / scenario B for a particular person/couple.
The marginal tax rate is used in this manner because it is, by definition, meant to measure at the margin the impact of making a certain change or implementing a certain strategy, by evaluating the tax obligation in scenario A, and scenario B, and the relative difference between the two.
This makes marginal tax rates especially useful in evaluating income deferral or acceleration strategies, from Roth conversions or contributing to an IRA to using a tax-deferred annuity to deciding whether to harvest capital gains or capital losses.
The Bottom Line
The marginal tax rates measure the incremental tax consequences between strategies (scenario A vs scenario B), while effective tax rates measure the relative tax obligations of different people (person A vs person B) or simply a person's total tax obligation relative to income (e.g., to understand how much of their income they keep over time).
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