What You Need to Know About the Effective Tax Rate

As a taxpayer, you probably hear and see a lot of terms. And, with so many terms being thrown around, it’s very easy to get confused. However, one important term you shouldn’t be confused about is what is known as your “effective tax rate.”   

This rate can be defined as the percentage of your taxable income that you pay via taxes. And, since it relates to what you actually pay in taxes each year, it’s important to understand it fully. Of course, this rate does not determine how much tax you owe, but it can enable you to comprehend whether you are likely paying too much in taxes.  

Effective Tax Rates for Individuals  

One of the first things to understand is that an effective tax rate is defined differently for individuals than it is for businesses.For individuals, it’s simply the average taxation rate for their earned income. Thus, if you don't own a business and don’t have to file business taxes, your effective tax rate is fairly easy to understand.  

Effective Tax Rates for Businesses  

Of course, if you own a business, things get a bit more complex. In this case, your effective tax rate is based on your pre-tax profits.  

Is Effective Tax Rate the Same as Marginal Tax Rate?  

Whether you are a business filer or an individual filer, make sure you do not confuse your effective tax rate with your marginal tax rate. Generally, an effective tax rate is more correct since marginal rates are based on the highest possible tax bracket a person or entity could fall into.  

Does Your Effective Tax Rate Actually Matter?  

With so many tax rate definitions, does your effective tax rate actually matter? The answer is both yes and no. This rate is essentially just a way to see how you fare in terms of other similar taxpayers. But, it can be helpful for planning your budget and knowing where you stand. 

Thus, if you’re unsure about your effective tax rate, how it may affect you, or what it says about the decisions you should be making, do not hesitate to contact a tax professional for guidance and advice.