How to Calculate Effective Tax Rate

One of the leading questions when it comes to tax preparation is, what determines my tax rate? Tax rate measures the percentage of your income that you pay in taxes. Understanding your tax rate is important because it can help you better strategize your taxes, and that could save you big money in the long run. Your actual tax rate percentage is called the effective tax rate, and it tells you the portion of your income that you will owe in income taxes. 

effective tax rate formula

What is Effective Tax Rate?

The effective tax rate is the actual amount of taxes a taxpayer will pay on their earned income. This term refers to income tax and excludes payments made to FICA, self-employed taxes, and state and local taxes. The effective tax rate is also referred to as the average tax rate. You hear the terms effective and marginal tax rate quite a bit, what you need to know is that the effective tax rate is lower than the marginal tax rate, and represents the actual percentage you pay in taxes. 

Effective Tax Rate Formula

Determining one’s tax rate is a bit complex. The US tax code is a progressive tax system, so not all of your income will be taxed the same. In fact, depending on your taxable income and tax brackets, if your income spans more than one tax bracket, you may be taxed at two different percentages. But more on that later. To calculate your effective tax rate, you need to know two numbers: your total earnings and total tax bill. To calculate your effective tax rate divide your taxes paid by taxable income and you get the effective tax rate.

ETR = Taxes paid  ÷  Earned Income

What Tax Bracket Am I In?

The tax bracket you are in has a lot to do with your effective tax rate. There are currently 7 tax brackets that range from 10% to 37%. The tax bracket you are in will depend on your taxable income and how you file. Due to the fact that the US tax system is a progressive tax system, your income may not be taxed in just one tax bracket. For example, if you are a single tax filer who made $45K, the first $39,475 would be taxed at 12%, the remaining $5,525 would be taxed at 22%. This applies to your taxable income. You can learn more about tax brackets here

How to Reduce Taxable Income

One of the main components in calculating the effective tax rate is determining your taxable income. The lower your taxable income is, the less you will pay in taxes. This is where a well thought out tax strategy comes into play. You can successfully lower your taxable income by leveraging adjustments and deductions. Knowing where to look for deductions is important, and something a good tax advisor can help you out with. 

Charitable Contributions

One deduction that can really pay off, is the charitable contribution deduction. Not only can you help out a cause you believe in, but you can also reduce the amount of taxes you owe. When making charitable contributions it is important to make sure you are donating to a qualified organization. You can look up an organization’s determination letter on the IRS website. Some examples of charitable organizations include churches, non-profit schools, hospitals, and social welfare organizations.  You can donate up to 60% of your Adjusted Gross Income (AGI) to these types of organizations. Be sure to keep accurate records of all transactions. In addition, costs associated with donating including mileage (14 cents per mile), appraisal costs, hard costs associated with putting on a charitable event, and ticket costs are also tax-deductible.

effective tax rate charitable contributions

Deductions and Write-Offs

Deductions are a taxpayer’s best friend. They are completely legitimate and can really add up. For business owners and independent contractors, deductions come in the form of ongoing business expenses that are considered ordinary and necessary to your business. This includes cell phone, depreciation, education, equipment, home office expense, insurance, internet, marketing, mileage, office supplies, travel, and utilities to name a few. If it applies to your business, chances are it can qualify as a deductible expense. 

A few things to keep in mind when it comes to deductions, if you claim the home office deduction, you cannot then claim the individual expenses. The same goes for the standard mileage deduction. You can either claim the individual expenses or take the standard deductions that apply. When it comes to deductions, it is really important to have an organized accounting system in place. This helps ensure that you are getting all of the deductions available to you, and also provides a record in case the IRS has any questions. 

Retirement Account Contributions

Contributing to your retirement is a great way to set yourself up for the future, but it can also provide a tax benefit. You can deduct up to $6,000 under the IRS contribution limits. This is considered an above the line deduction, so you can use it regardless of whether you itemize.  Taxpayers have until April 15 to make contributions for the previous year, so if you are looking for a last minute deduction, consider making a last-minute contribution to your IRA.

Minimizing Your Effective Tax Rate

Nobody likes to pay taxes. Lower your taxable income is the best way to reduce your effective tax rate. By lowering your net income, you can reduce the amount you will owe. This can be achieved by utilizing the strategies mentioned above; donating to charity, leveraging deductions, and contributing to your retirement. Some other things you can do to minimize your tax bill include: timing income and expenses, timing large purchases, and creating a tax savings account. 

Maximize Tax Savings With a Pro Advisor

A tax advisor can help you get the best deal possible on your income taxes. Get started today with a free one-on-one strategy session with a Shared Economy Tax pro. For more tips on how to lower your taxable income subscribe to our newsletter using the form below. 

About the Author

Chris Dios