Effective Tax Rate: How It's Calculated and How It Works

What Is the Effective Tax Rate?

The term effective tax rate refers to the percent of income that an individual or 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.

How to Calculate the Effective Tax Rate

The effective tax rates for individuals and corporations can be calculated as follows:

So if you want to calculate your effective tax rate, here's how you do it:

• An individual can calculate their effective tax rate by looking at their Form 1040 and dividing the total tax, which is the number found on line 24, by the taxable income figure found on line 15 and multiplying the result by 100.
• For corporations, the effective tax rate is computed by dividing total tax expenses by the company's earnings before taxes.

How the Effective Tax Rate Works

As noted above, the effective tax rate is the average tax rate of a taxpaying entity. This includes both individual taxpayers and corporations. The effective tax rate is expressed as a percentage.

The effective tax rate typically refers only to federal income taxes and doesn't take into account any other types of taxes, including:

• State and local income taxes
• Sales taxes
• Property taxes
• Other types of taxes an individual might pay

To determine their overall effective tax rate, individuals can add up their total tax burden and divide that by their taxable income. This calculation can be useful when trying to compare the effective tax rates of two or more individuals, or what a particular individual might pay in taxes if they lived in a high-tax vs. a low-tax state—a consideration for many people thinking about relocating in retirement.

Effective Tax Rate vs. Marginal Tax Rate

The effective tax rate is a more accurate representation of a person's or corporation's overall tax liability than their marginal tax rate, and it is typically lower. When considering a marginal versus an effective tax rate, bear in mind that the marginal tax rate refers to the highest tax bracket into which their income falls.

In a graduated or progressive income-tax system, like that in the United States, income is taxed at differing rates that rise as income hits certain thresholds. Two individuals or companies with income in the same upper marginal tax bracket may end up with very different effective tax rates, depending on how much of their income was in the top bracket.

Federal Tax Brackets

Federal tax brackets are determined and passed into law. These brackets are overseen in the U.S. by the Internal Revenue Service (IRS). The amount of income and tax filing status determines the tax brackets in which individual taxpayers fall.

The table below highlights the tax brackets in the United States for the 2024 and 2025 tax years.

Example of an Effective Tax Rate

Imagine, for example, a graduated tax system where income under $100,000 is taxed at 10%, income between $100,000 and $300,000 is taxed at 15%, and income over $300,000 is taxed at 25%. Now consider two individuals who both hit the upper tax bracket of 25%, although one had a taxable income of $500,000, while the other had a taxable income of $360,000.

Both individuals would pay 10% on their first $100,000 of income, or $10,000. Both would then pay 15% percent on their income between $100,000 and $300,000, or $30,000 (15% of $200,000).

Finally, both would also pay 25% on their earnings over the $300,000 threshold. For the individual with $360,000 in taxable income, that would come to $15,000 (25% of $60,000). But for the individual with $500,000 in taxable income, the tax would be $50,000 (25% of $200,000). Their total tax obligations would be $55,000 and $90,000, respectively.

While both individuals could say they're in the 25% bracket, the one with the higher income has an effective tax rate of 18% ($90,000 in tax divided by $500,000 in income), while the other's effective tax rate is 15.3% ($55,000 divided by $360,000).

The Bottom Line

Your effective tax rate is the percentage of tax you owe on your taxable income. This is based on brackets set and maintained by the IRS. You can easily figure out your effective tax rate by dividing the total tax by your taxable income from Form 1040. For corporations, the effective tax rate is calculated by dividing the total tax by earnings before interest. If you're unsure about anything related to your taxes, make sure you consult a tax advisor or professional who can guide you in the right direction.