How Knowing The Difference Between Effective And Marginal Tax Rates Will Change The Way You Listen To Politicians

Step one to understanding a politician's economic plan and how it will affect your personal finances: Learn the difference between effective and marginal tax rates.

Mint Life, a personal finance advice and news blog, has a perfect example (written in 2012, but still very valid today) that demonstrates the importance of understanding the concept between the two.

Mint Life portrayed a (fictional) man in California who owns a successful business and pays himself a high salary that puts him in the highest federal tax bracket of 39.6 percent. Adding payroll tax, tax on dividend payment stocks, sales tax, local business tax and property taxes brings his total tax rate to 99.27 percent.

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In other words, if this person earns a cool million bucks a year, he gets to keep for himself $7,300.

The only problem is, this isn't how taxes work, and Mint Life couldn't stress how important it is that everyone, including members of the press "should know better."

'Knowing Better'

Mint Life went on to explain how to better understand the tax code. For starters, the tax code is full of exemptions, deductions and credits to the point where a gross income of $400,000 can turn into a taxable income of $300,000 and an income of $40,000 can turn into a taxable income of zero.

The author of the blog post, Matthew Amster-Burton, used his own finances as an example. His family made $91,000 before taxes. After credits, deductions and exemptions, the family's taxable income was $60,000, which put the family in the 15 percent tax bracket.

"Our effective tax rate — the percentage of our income that actually went to federal income tax — was 8.4 percent," he explained. "We didn't do anything sneaky to achieve these numbers; they're typical for people in our income range and our effective tax rate would have been even lower if we owned a house and paid mortgage interest."

He went on to explain the difference between his family's effective tax rate and the marginal rate.

"Currently — for tax year 2012 — the highest tax bracket is 35 percent, for anyone (single or married) making more than $398,350," he continued. "For those high-income folks, 35 percent is their marginal rate, meaning each additional dollar they make is taxed at 35 percent."

"That doesn't mean, however, that a person making $400,000 turns 35 percent of it over to the IRS."

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