Knowing your effective tax rate provides you with a clear picture of your tax liability for each year of the year in question. Keeping track of it on a yearly basis allows you to make modifications to your withholding amount and plan for the upcoming year ahead of time.
If your tax preparer does not present you with your effective tax rate, it is straightforward to figure out what that rate is.
Additionally, US News says that your effective tax rate is a strong measure of how well you’ve been managing your tax situation, which is beneficial for both planning and reporting purposes.
What is an effective tax rate?
According to Corporate Finance Institute (CFI), when referring to an organization or a person, the effective tax rate can be defined as the average rate of tax payable by the organization or person. The effective tax rate is the average rate at which an individual’s earned and unearned income is taxed over the course of their lifetime. But experts say it’s better to add state and local taxes to get the full picture.
Isn’t it common for people to think that the rate at which you fall into a tax bracket determines how much you pay in taxes? For example, you might be in a tax bracket where you pay 24% of your income in taxes.
But your actual tax bill is based on your effective tax rate. There are times when you pay a lot more taxes in the long run than you do in the short run. This is because your tax is collected at different rates at different income levels, which makes your effective tax rate a better way to figure out how much you pay in taxes each year.
How to calculate your effective tax rate?
Your effective tax rate can be calculated by taking two numbers: the total amount of taxes paid in 2021 and your taxable income in the same year as the tax payment. Here’s the formula: Total Tax ÷ Taxable Income = Effective Tax Rate
Both of these numbers may be found on your tax return with relative ease. Line 24 of Form 1040, which is part of your federal tax return, contains the amount of total tax you owe.
Your taxable income is equal to your gross income less the standard deduction ($12,550 if you are single, $25,100 if you are married filing jointly) or itemized tax deductions, as well as any applicable tax adjustments. Line 15 of Form 1040 contains the amount that must be reported.