"How do I avoid this?" I asked my accountant, who was on the phone walking me through my tax return.
"What you really need to think about is your effective tax rate," he said.
I had never heard of the term before, despite years of trying to learn everything I could about filing taxes as a self-employed person. But, after listening to my accountant talk for a few minutes I realized that he had just provided me with the missing tool that I needed to take better control of my taxes and avoid owing the IRS a massive sum of money at the end of the year.
Tax brackets vs. effective tax rate
It's well known that the US relies on a system of tax brackets . Up to a certain income, your money is taxed at one rate. After you break into the next bracket, the remainder of your income is taxed at the new, higher rate (but not all your income that's a common misunderstanding ).
In 2019, my family's income fell into the range that is taxed at 22%. But I knew from years of monitoring my tax payments that I wasn't paying anywhere near that much to the IRS. With two kids, a home office, and mortgage interest and student loan interest deductions, the amount I was actually paying was much less than that. I just didn't know exactly how much less, so I was left guessing about how much of my income I should set aside for taxes.
Then, my accountant mentioned the term "effective tax rate." Your effective tax rate is the percentage of tax that you actually end up paying, once you've accounted for all your deductions, credits, and income taxed at lower amounts. This is usually much lower than your marginal tax rate , the "bracket" we all love to complain about.
In 2019, the average effective tax rate for Americans was 18.8%, but for most of us it was lower than that. If you divide American earners into five groups based on income, the lower-earning three groups have an effective tax rate of less than 13%. The fourth group has an effective tax rate of nearly 17%, while the top-earning fifth of the population has an effective tax rate of nearly 24%.
Why knowing your effective tax rate is useful
After talking with my accountant, I knew that my effective tax rate is roughly 13%. As a self-employed person, knowing this feels like a decoder to a secret language. Now, instead of just paying the quarterly payments that my account recommended when I filed last-year's taxes, I can make an accurate prediction of exactly how much I owe each quarter based on my earnings.
Consider the first two quarters of 2020. After filling my 2019 taxes, my accountant told me that my quarterly tax payments would be about $3,300 this will essentially cover the tax I paid last year, meaning I'll be all set if my income remains the same. For the first quarter, that $3,300 was almost exactly 13% of my gross earnings. Great! For the second quarter, 13% of my gross earnings were about $3,800, so I knew I should pay more than the required amount.
I hope to continue growing my businesses, which means I'll likely owe more taxes for 2020 than I did for 2019. Knowing about my effective tax rate helps me predict exactly how much, so that I will (hopefully) avoid a massive tax bill at the end of the year.
Calculating your effective tax rate
If you want to know your effective tax rate, the math is simple . Look at how much you paid in taxes last year. Then, divide that by your total taxable income if you're calculating for an individual. If you're calculating for a corporation, divide the amount of taxes paid by pre-tax earnings.
I'm not a tax professional by any means (looking at my tax bill from last year will tell you that). But as a business owner hoping to better understand how to meet my tax burden while also maximizing my cash flow, understanding my effective tax rate has been a great tool one that I wish I had discovered sooner.
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