Many folks feel overwhelmed by any talk around taxes. This is understandable. Our federal tax code can be a tough code to crack. It is a moving target of rules, income phaseouts and brackets which seem to change on a near constant basis.
And then there is simply the tax terminology in general that can be very confusing.
Effective Tax Rate vs Marginal Tax Rate
We follow a progressive tax system in the US. This means the amount of tax we pay on the first dollar we earn is less than the tax we pay on the last dollar we earn.
This progression results in a taxpayer’s Effective Tax Rate, or average overall tax rate, being less than their Marginal Tax Rate, or the tax rate of their final dollar(s) earned.
It tends to be a taxpayer’s marginal tax rate that is referred to most often, however it is the effective tax rate that more accurately reflects the average amount of tax you pay.
When a taxpayer falls into the 24% tax bracket for example, this is their marginal tax rate…24%. This simply means that the highest level of tax paid was 24%, even if it was only $1 of income in that bracket.
But their effective tax rate, the amount of tax they paid as a percentage of their overall income, is typically lower.
If your accountant supplies a comparison worksheet, you may be able to see your marginal and effective tax rates at the bottom of the worksheet.
Amount You Owe vs Total Tax Liability
If you look at page 2, line 37 of your 1040 for 2022, you’ll see “Amount You Owe”.
This is NOT your total tax liability for the year, which is up above on line 24, aptly named “total tax”.
Amount you Owe is what is still left to pay of your total tax liability for the year, unless of course, you are getting a refund (which is on line 34 this year).
Your total tax liability in any given year depends on many different factors, so even if the figure on line 37 is higher this year, it doesn’t necessarily mean you are paying more in taxes.
You have to take into account what percentage of your overall income that number represents, which as you read above, is your effective income tax rate.
Let’s compare apples to apples:
In 2021, I picked 100 apples and had to give 20% of them to Uncle Sam.
That’s 20 apples (Total Tax, line 24).
I paid in 1 apple each month for the year (12 apples), so in April I still owed 8 more apples (Amount You Owe, line 37).
In 2022, I picked 200 apples and had to give 20% of them to Uncle Sam.
That’s 40 apples (Total Tax, line 24).
I paid in 1 apple each month for the year (12 apples), so in April I still owed 28 more apples (Amount You Owe, line 37).
Since owing 28 in 2022 is a lot more than owing only 8 in 2021, it would appear I paid more in taxes in 2022, and as a flat number of apples I did.
As a percentage of my overall apple income, I owed the same amount – 20%.
I picked more apples (earned more income) but paid in the same number of apples each month (paycheck withholdings), so I had to play catch up in April and give a whole bunch of apples at once (amount you owe).
And despite the fact that I just explained to you how we have a progressive tax in this country, for the purposes of this illustration, I wanted to keep it simple and not overturn the apple cart.
I know, even trying to keep taxes simple can sound confusing, but I hope this helps shed at least some light on this intimidating subject!
Always have eyes that see the best, a heart that forgives the worst, a mind that forgets the bad, and a soul that never loses hope.