Question

There are several different types of tax rates that taxpayers might use in different contexts. Describe each tax rate (average, effective, and marginal) and how a taxpayer might use it for tax planning.

Answer 1

Effective Rate?
The effective tax rate is the percent of their income that an individual or a corporation pays in taxes. The effective tax rate for individuals is the average rate at which their earned income, such as wages, and unearned income, such as stock dividends, are taxed. The effective tax rate for a corporation is the average rate at which its pre-tax profits are taxed, while the statutory tax rate is the legal percentage established by law.

Effective tax rate represents the percentage of their taxable income that individuals pay in taxes.
For corporations, the effective corporate tax rate is the rate they pay on their pre-tax profits.
Effective tax rate typically refers only to federal income tax, but it can be computed to reflect an individual's or a company's total tax burden

What Is the Marginal Tax Rate?
The marginal tax rate is the tax rate you pay on an additional dollar of income. In the United States, the federal marginal tax rate for an individual increases as income rises. This method of taxation, known as progressive taxation, aims to tax individuals based upon their earnings, with low-income earners being taxed at a lower rate than higher-income earners.

The marginal tax rate is the tax rate paid on the next dollar of income.
Under the progressive income tax method used for federal income tax in the United States, the marginal tax rate increases as income increases.
Marginal tax rates are separated by income levels into seven tax brackets.

What is the average tax rate?
The average tax rate is the percent of taxes divided by taxable income. Because of the U.S.’s progressive tax system, people pay different percentages of tax the higher their income gets. The average tax rate helps them figure out how much tax was paid overall.

In the U.S., taxes are calculated according to the amount earned under each income tax bracket, which is called a progressive tax system. Taxpayers pay less in lower income brackets, more in higher brackets, which is called a marginal tax rate. Every dollar they earn above their current bracket is taxed at the next one.

The average tax rate equals total taxes divided by total taxable income. Calculating the average tax rate involves adding all of the taxes paid under each bracket and dividing it by total income. The average tax rate will always be lower than the marginal tax rate.

What Is Tax Planning?
Tax planning is the analysis of a financial situation or plan from a tax perspective. The purpose of tax planning is to ensure tax efficiency. Through tax planning, all elements of the financial plan work together in the most tax-efficient manner possible. Tax planning is an essential part of an individual investor's financial plan. Reduction of tax liability and maximizing the ability to contribute to retirement plans are crucial for success.

How Tax Planning Works
Tax planning covers several considerations. Considerations include timing of income, size, and timing of purchases, and planning for other expenditures. Also, the selection of investments and types of retirement plans must complement the tax filing status and deductions to create the best possible outcome

Tax planning is the analysis of finances from a tax perspective, with the purpose of ensuring maximum tax efficiency.
Considerations of tax planning include timing of income, size, timing of purchases, and planning for expenditures.
Tax planning strategies can include saving for retirement in an IRA or engaging in tax gain-loss harvesting.