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Marginal Tax Rates vs Effective Tax Rates: What’s the Difference?

Tax brackets are one of the most misunderstood concepts in taxes. You’ve probably heard people say (or said it yourself) that if you make more money, your income will go down because of the taxes. But that’s not how taxes work. 

As physicians, the biggest line item in your budget is taxes. Understanding tax brackets is a critical financial strategy, especially in areas like retirement planning, income splitting, and maximizing tax deductions and credits.

In this post, we’ll look at how marginal tax rates and effective tax rates differ and potential moves you can make to minimize the taxes you pay over your lifetime.

 

What Is Marginal Tax Rate?

Marginal tax rate is the tax rate applied to your last dollar of income. 

So if your income falls into the 35% tax bracket, that means your last dollar of income is taxed at 35%, not that all your income is suddenly taxed at 35%. 

Each tax bracket (ranging from 0-37%) represents a portion of your income. Only the income that falls into each bracket is taxed at that rate. So, if you move from the 28% bracket to the 35% tax bracket, only the income that falls into that last bracket is taxed at 35%, while your prior income is taxed as it was before.

Because physicians fall into the higher tax brackets, understanding how the last dollars are taxed is key to making decisions, such as whether an investment opportunity is worth the risk when looking at after-tax returns or whether picking up that extra shift in the ER is worth it. 

 

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What Is Effective Tax Rate?

effective tax rate is the average tax rate you pay. Instead of looking at just the last dollar, like the marginal tax rate, the effective tax rate looks at all the taxes you’ve paid in all of the tax brackets.

The effective tax rate is a broader view of your tax situation, showing how much of your average income goes to taxes.

The major difference between these two rates is perspective. The marginal tax rate looks at one specific part of your income – the top – while the effective tax rate takes a step back to view the entire picture. For instance, even if your last dollar is taxed at a high rate (marginal tax rate), your overall income may be taxed at a lower average rate (effective tax rate), considering the lower tax rates on the initial steps of your income.

Understanding these two types of tax rates is essential, especially for high-earning professionals. It provides a clearer picture of tax obligations and helps in effective financial planning. Remember, the marginal tax rate tells you about the tax rate on the next dollar earned, while the effective tax rate gives you an overview of your overall tax burden.

 

Why Understanding Tax Rates Matters for Physicians?

As a physician, for most of your career, you will most likely fall into one of the higher tax brackets. Understanding how the brackets work can help you make sound, long-term financial decisions.

 

1. Financial Planning

Figuring Out Takehome Pay: Most people experience the shocking bite taxes can take from their paycheck when they get their first job. But that’s nothing compared to the withholding that you’ll see on a mid-six-figure income. Understanding your effective tax rate will help you figure out how much you should be taking home from each paycheck and adjust your withholdings if they’re not correct.

Budgeting and Savings: When budgeting it’s vital that you know how much you are taking home after taxes by being aware of your effective tax rate. This will help you determine how much you can save for retirement and other financial goals. Understanding your marginal tax rate will help you figure out how much that extra shift boost your paycheck.

Strategic Income Planning: Marginal tax rates can help you plan larger financial moves such as determining which years a Roth conversion makes sense or when to realize capital gains. 

 

2. Investment Decisions

Tax-efficient Investing: Investment decisions can be significantly impacted by tax considerations. You need to understand how their investments will be taxed, which depends on their marginal tax rate. For instance, if you are in a higher marginal tax bracket, tax-deferred retirement contributions may make more sense than after-tax contributions.

Capital Gains: Long-term capital gains have their own tax brackets, although the tax brackets for your capital gains are affected by your overall income. Understanding which tax bracket your capital gains fall into may affect the timing of when you choose to realize your gains.

 

3. Tax Liabilities

Planning for tax bills: If you understand both your marginal and effective tax rate, you can better plan for your upcoming tax bill. No one likes a surprise on tax day. By staying on top of your taxes throughout the year, you can make appropriate estimated tax payments, which will help you avoid penalties and interest.

Tax reduction strategies: Keep in mind that a deduction is more valuable to someone in a 35% tax bracket than it is to someone in the 24% tax brackets. Knowing which bracket you are in this year and your anticipated tax bracket for next year may influence the timing of charitable contributions or real estate tax payments. 

Alternative Minimum Tax (AMT): Prior to the Tax Cuts and Jobs Act, many physicians fell into AMT which reduced the benefits of many deductions such as state tax payments. Though very few taxpayers are affected by AMT, the old rules are (currently) scheduled to come back in 2026.

 

Examples of Tax Brackets and Their Impact

Let’s look at a few examples to illustrate the difference between marginal and effective rate rates.

 

Example 1:

Gross Income: $40,000

Standard Deduction: $13,850

Taxable Income: $40,000 – $13,850 = $26,150

The 2023 tax brackets for a single filer were approximately:

10% on the first $11,000

12% on income between $11,001 and $44,725

22% on income between $44,726 and $95,375

24% on income between $95,376 and $182,100

 

So, the tax calculation would be:

10% of $11,000 = $1,100

12% of ($26,150 – $11,000) = 12% of $15,150 = $1,818

Total Tax: $1,100 + $1,818 = $2,918

 

Marginal tax rate: 12%

Effective rate rate: 7.3% ($2,918 / $40,000)

 

Example 2

Annual Income of $120,000

Standard Deduction: $13,850

Taxable Income: $120,000 – $13,850 = $106,150

 

So, the tax calculation would be:

10% of $11,000 = $1,100

12% of ($44,725 – $11,000) = 12% of $33,725 = $4,047

22% of ($95,375 – $44,725) = 22% of $50,650 = $11,143

24% of ($106,150 – $95,375) = 24% of $10,775 = $2,586

Total Tax: $1,100 + $4,047 + $11,143 + $2,586 = $18,876

 

Marginal tax rate: 24%

Effective rate rate: 15.7% ($18,876 / $120,000)

 

Smart Financial Moves Using Knowledge of Tax Brackets

 

Retirement Planning

Depending on your current tax bracket and anticipated bracket in retirement, you can choose between Roth and Traditional retirement accounts. If you’re currently in a high tax bracket and expect to be in a lower one during retirement, a Traditional IRA or 401(k) allows you to defer taxes until withdrawal. Conversely, if you’re in a lower bracket now, a Roth IRA or Roth 401(k), with its tax-free withdrawals in retirement, could be more beneficial.

If you have multiple retirement accounts (e.g., traditional and Roth IRAs), you can plan withdrawals to minimize your tax burden, taking from taxable accounts when you’re in a lower tax bracket and from tax-free accounts when you’re in a higher bracket.

 

Income Splitting and Timing

You might shift some income to a spouse or a family member in a lower tax bracket through a family business or by gifting assets that produce income. Note that you should consider the kiddie tax rules before shifting assets to your children, and community property rules may affect your options.

If you have control over the timing of your income, like bonuses, business income, or capital gains, you can time these for years when you expect to be in a lower tax bracket. This is particularly relevant if you might take a sabbatical or plan a semi-retirement.

 

Tax Deductions and Credits

Knowing your marginal tax rate can help determine the best time to make deductible expenses. For example, if you’re in a high tax bracket for one year due to exceptional income, it might be a good year to make large, deductible purchases or contributions.

If you typically itemize deductions, you might choose to pay two years’ worth of property taxes or make two years’ worth of charitable contributions in one year, exceeding the standard deduction threshold and reducing your taxable income more significantly.

Tax credits are direct reductions of your tax bill and can be extremely valuable. Familiarize yourself with available tax credits, such as those for education, energy-efficient home improvements, or electric vehicles.

 

Anticipated Changes in 2026 and Their Implications

The year 2026 is set to mark a significant shift in the tax landscape due to the scheduled expiration of the Tax Cuts and Jobs Act (TCJA) of 2017.

Reversion of Tax Rates: The TCJA introduced lower individual income tax rates, which are set to expire at the end of 2025. In 2026, current rules will lead to a reversion to the pre-TCJA tax brackets, which generally means higher tax rates for most income levels.

Changes in Deductions and Exemptions: The TCJA nearly doubled the standard deduction and eliminated personal exemptions. Post-2025, the standard deduction is anticipated to decrease, and personal exemptions may return, affecting taxable income calculations.

Potential Changes in Child Tax Credit: The TCJA increased the Child Tax Credit and made it more widely available. These changes may revert back in 2026, affecting families with dependent children.

Estate Tax Exemption: The TCJA doubled the estate tax exemption, but this is also set to revert to previous levels, impacting estate planning strategies.

 

Final Thoughts

The importance of understanding tax rates for physicians cannot be overstated. Physicians face unique financial challenges and opportunities as professionals, often in higher-income brackets.

Knowledge of marginal and effective tax rates is a practical tool for smart financial decision-making. By understanding how much of their income goes to taxes and how this can change with varying income levels, you can make more informed decisions about budgeting, savings, and investment strategies.

Anticipating changes in tax laws, such as those expected in 2026, allows physicians to plan ahead and adapt their financial strategies accordingly. This foresight can lead to significant tax savings, helping to maximize their hard-earned income, whether choosing the right retirement accounts, timing income and deductions, or implementing tax-efficient investment strategies.

 

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