You pay taxes.
That much in and of itself should not come as a surprise. (If it is, we apologize for breaking the news in such a blunt fashion. You should probably talk to an accountant and an attorney right away, though.) How much you pay in taxes, that's more complicated.
The American tax code has several layers to it. It taxes incomes at graduated rates, with different levels for different forms of income and deductions that change how much you pay depending on thousands of possible circumstances. The result is that for every earner there's a difference between what you pay in theory and how much you actually hand over to the Internal Revenue Service (IRS).
The actual payments are called your "effective tax rate." Here's what you need to know about it.
What Is the Effective Tax Rate?
The effective tax rate is the actual amount of federal income taxes paid on an individual's taxable income. It refers only to federal income taxes, and so excludes payments such as FICA taxes, the self-employment tax, state taxes and local taxes. The alternative to the effective tax rate is measuring an individual's marginal tax rate, which is the highest bracket at which their income is taxed.
For example, say that Steve is an unmarried individual who earned $75,000 in taxable income in 2022. (We will assume away any additional deductions, credits, or other complications.) His marginal tax rate would be 22%. That's the highest bracket at which Steve's income would be taxed. However, his effective tax rate would be approximately 16.156%. That's how much Steve would actually pay in income taxes.
How to Calculate the Effective Tax Rate
The simple way to calculate an effective tax rate is to divide the total income that an individual pays by their total taxable income. In our example above, Steve would have paid about $12,117 in federal taxes on his 2022 income. That gives us the formula:
Effective Tax Rate (ET) = Taxes Paid / Taxable Income
Inputting Steve's data, that becomes $12,117 / $75,000 = 16.156%.
An individual's effective tax rate represents the average of all tax brackets that their income passes through as well as the total of all deductions and credits that lower their total income to their taxable income. To understand this, we need to first understand those two concepts.
How Tax Brackets Work
There are two main theories behind income taxes. The first is called a flat tax system, under which all individuals pay the same rate regardless of income. For example, a flat tax might simply say that everyone must pay 10% of their income regardless of whether they made $50,000 or $10 million.
The second theory is called progressive taxation. Under this system, individuals pay a higher percentage of their income—the more money they earn, the higher the tax rate. For example, under a progressive system, someone might pay 10% of their income if they made $50,000 and 40% of their income if they made $10 million.
In practice, progressive tax systems generally use a hybrid flat/progressive approach called tax brackets. This is the most common way to implement progressive taxation schemes worldwide.
Under a bracket system, the government comes up with tiers, or "brackets," of income tax rates and assigns a range of income to that bracket. All of an individual's income within that bracket is taxed at the assigned rate and each bracket only applies to its own range of income. For example, for the 2023 tax filing season on 2022 income, the U.S. has seven federal tax brackets.
For single (or unmarried) individuals, the tax brackets are:
This means that in 2022 the first $10,275 that a single-person household filer makes is taxed at 10%. Then their income graduates to the next bracket but only the additional income is taxed at the higher rate. Here, they would pay 12% only on the portion of their income between $10,275 and $41,775. In the subsequent bracket, they would begin paying 22% on the portion of their income above $41,775, and so on.
Example of Effective Tax Rate
For example, say that someone made $50,000 in 2022. Their income tax calculation for 2023 might look like this:
- $0 – $10,275 at 10% = $10,275 of income taxed at 10% = $1,027.50
- $10,275 – $41,775 at 12% = $31,500 of income taxed at 12% = $3,780
- $41,775 – $50,000 at 22% = $8,225 of income taxed at 22% = $1,809.50
- Total taxes = $6,617
Notice that moving from one bracket to the next does not affect the tax status of any income below that bracket. This system is a hybrid of flat and progressive taxation. Every tax-paying American pays the same amount on their first $10,275 of income regardless of whether they make $50,000 or $50 million.
The bracket system is why the effective tax rate accurately describes an individual's actual liability. An individual's top marginal tax rate does not actually reflect how much they pay in taxes because that bracket only applies to their highest section of income.
In our example above, say, the person making $50,000 has a marginal tax rate of 22%, but that doesn't mean he paid 22% of his income in taxes. That would have come out to $11,000, when in reality he paid closer to half that. The effective tax rate on this individual was 13.2%, the amount of his income he actually paid due to the fact that each tier of his income was taxed at a different rate.
How Taxable Income Works
The other key component of an effective tax rate is what is known as "taxable income." Simply put, the amount you make is not the amount you pay taxes on. Sometimes it's not even close.
In this article, we have been using the idea of earnings and taxable income interchangeably, but that's not the way it works. Taxable income is the amount of your income left after applying deductions, credits, and any other income adjustments. You only pay taxes on income after calculating these deductions.
For example, everyone who does not take a line-item deduction is entitled to take the standard deduction. On 2022 income for the 2023 filing season, that's $12,950 for single filers. This means that an individual who made $75,000 could reduce his taxable income to $62,050. For the purpose of income tax payment calculations, she is considered to have made $62,050.
Your effective tax rate is the average amount of taxes you paid on your taxable income, not your total income. So in our example above, the individual would divide her tax payment by $62,050, not by $75,000, to find her effective tax rate.
Effective Tax Rate Only Applies to Federal Income Tax
Finally, it's important to understand that your effective tax rate is not the total amount you pay in taxes.
The effective tax rate is the actual rate you pay in federal income taxes. However, all Americans pay a wide variety of taxes in addition to the federal income tax. (In fact, about 44% of Americans don't earn enough money to pay income taxes at all.) These can include payroll taxes (otherwise known as FICA taxes), state and local income taxes, and state and local sales taxes.
All of these count toward an individual's total tax burden, but not their effective tax rate.
How Do Tax Brackets Differ by Filers?
The tax bracket for married couples filing jointly would be different from single filers, and consequently their effective tax rate. And sometimes the IRS can change the tax brackets for different filers in succeeding years.
