Effective tax rate

[LWEME]

On page one of TurboTax it declares your effective tax rate. Does that mean the tax that you pay in total on your gross or adjusted gross and what does it mean.

[Corrlich44]

Great question LWEME,

Income taxes are computed on your TAXABLE INCOME (after taking the Standard Deduction or Itemizing more direct Deductions).

Each income tax bracket applies a tax rate to each level of income on a progressively growing level.

Once all the applicable income taxes are computed on the income falling within those tax brackets, the sum of all your income tax liabilities, including Self-Employment Payroll Tax, are divided against your Adjusted Gross Income to give you an Effective Income Tax Rate average.

I prefer to use Taxable Income as the denominator, which provides a clearer and more reliable average rate and not Adjusted Gross Income.

[LWEME]

Thank you. 

So if an AGI were $1000 (made up number) and it shows an effective tax rate as say 10% on the turbotax page, does that mean a person is in the "10% tax bracket?"

I also like your idea of using the taxable income as the denominator to see what that looks like too. 

Trying to learn better!

Thank you!

[Corrlich44 · Accepted solution]

Thanks for your thoughts.

Actually, it just means the average of all tax liabilities could average 10%

Assuming the tax year is 2022 and you are Single and your Taxable Income is $100,000:

The 1st income tax bracket of $0 to $10,275 is taxed 10%

The 2nd income tax bracket of $10,275 to $41,775 is taxed at 12%

The 3rd income tax bracket of $41,775 to $89,075 is taxed at 22%

The 4th income tax bracket of $89,075 to $170,000 is taxed at 24%

So....

$10,275 = $1,028

$31,500 =$3,780

$47,300 = $10,406

$10,925 = $2,622

Total Tax Liability = $17,836

Taxable Income = $100,000

Effective Tax Rate = 17.84%

So....

$10,925 of your taxable income falls within the 24% income tax bracket

That's how you would explain it using Taxable Income

If you use the Adjusted Gross Income for a Single Person, add back the Standard Deduction of $12,950 and your AGI becomes $112,950.

Your Effective Tax Rate then becomes 15.79% with, $10,925 of your taxable income falls within the 24% income tax bracket

[jjr37]

Dear Corrlich44:

Your example perfectly illustrates how the IRS determines your effective rate.  I also agree that the only meaningful "real" effective rate is obtained by dividing the total tax by taxable income. 

Unfortunately, that is not how TurboTax calculates what it calls "Effective Tax Rate".  They are using an indeterminate and unexplained formula that results in an "Effective Rate" that is significantly lower than that obtained  by dividing the Total Tax by Taxable Income. 

I haven't  tried creating a "dummy" return using simple figures like yours, but for a group of real returns, with multiple sources of income,  for 5 years (using Tax History Report), TurboTax's Effective Rate ranged from approx. 5% to 20% lower than the real rate.   This forum does not support attachments, or I would have included the Tax History Report with the names redacted,

I've tried searching "effective tax rate" and "how does TurboTax compute effective tax rate" in the help center (under Help in program) with no results.

[Corrlich44]

Hi jjr37,

I greatly appreciate your response on this question, I too have noticed how the Effective Tax Rate is being reported and it stems from a basic calculation: Total Income Tax Liability divided by Total Income.

I agree that it does not fairly represent what should be expected, but that is exactly how their program is computing the effective rate of tax being generated from all sources of income.

I've noticed this for some time and have brought it up with others. There may be a justifiable reason for the approach, but the only method that matters is the one the taxpayer can fully appreciate to their standards.

Great callout.

[jjr37]

Thanks for the reply.  Please answer the following:

What is Total Income Tax Liability, and how does it differ from Total Tax (the amount you actually pay)?

Where is Total Tax Liability shown in the program? 

With such a huge disparity (as much as 20+% in my experience) with an effective rate based upon what you actually pay, shouldn't this be corrected?  It is making a lot of people think that they are paying at a lower effective rate than they actually are.  

[DMarkM1]

You are correct there could be a big disparity.  The total tax liability is all taxes including any excise taxes for over contributing to retirement or HSAs and self-employment taxes, etcetera; generally those items on schedule 2 (and the list is long).  That total tax figure is more than income taxes. The total tax line also includes subtractions for nonrefundable credits not taxes the taxpayer actually paid.    

The income tax liability is generally line 18 however for the purist it may be line 16 plus any AMT from Schedule 2 line 1. 

As noted in the discussion a useful calculation for one may not be what another is looking for.  

TurboTax, it appears uses the total tax line / adjusted gross income to arrive at the effective tax rate.  

[jjr37]

I agree with both responders that different people may need the information for different purposes.  Going through this exercise, I realized that what most people probably need is a taxpayer's top incremental tax rate, which TurboTax accurately reports as "Tax Bracket", as this must be used to determine the tax effect of any incremental change in income.  Examples are decisions involving advancing or deferring income and deductions , or for comparison of taxable vs. tax-exempt bond fund yields - all must be calculated using the top bracket.   

The reason that I asked for the definition of Total Tax Liability is that one responder said that it was used in the Effective Tax Rate calculation.   On the other hand, using AGI results in a figure that's closer to TurboTax's number, but  not always.  So there must be some other included value.  In my analysis of 6 consecutive returns for the same payer, Total Tax divided by AGI only once resulted in an exact match with the reported Effective Tax Rate;  3 other years had a less  than 1% difference, and the remaining  two had 3% and 11% differences.   

Thanks again all.

[NumbersGuy2]

Thanks for this post.  For years, I thought I was going crazy because TurboTax's "effective tax rate" most assuredly never equals TotalTax/AGI nor does it equal TotalTax/TaxableIncome

It's annoying as heck.

Yet, Intuit's help info says, "Your 'effective tax rate' is the average percentage of your taxable income that you owe in federal taxes. In order to calculate this rate, you simply divide your tax liability (what you owe) by your total taxable income."

I wish Intuit would fix this or explain what they're really doing.

[CyberDimension]

The effective tax rate refers to the average percentage of your taxable income that you owe in federal taxes. It is calculated by dividing your total tax liability (the amount you owe) by your total taxable income. The effective tax rate takes into account the progressive nature of the tax system, where different income levels are subject to different tax rates.

In the TurboTax a TurboTax employee explains how the effective tax rate is determined using an example. They mention that income taxes are computed based on your taxable income, which is the income remaining after taking deductions such as the standard deduction or itemized deductions. Each income tax bracket applies a tax rate to the corresponding level of income. By calculating the tax liabilities for each bracket and summing them up, you can determine your total tax liability.

In the example given, they assume a taxable income of $100,000 for a single individual in the tax year 2022. They break down the income into different tax brackets and calculate the corresponding tax liabilities for each bracket. Finally, they divide the total tax liability by the taxable income to determine the effective tax rate.

It's important to note that the effective tax rate calculated by TurboTax may differ from the rate obtained by dividing total tax by taxable income. Some users in the discussion expressed their observations of a disparity between TurboTax's effective tax rate and the rate calculated using total tax and taxable income. This could be due to the specific method used by TurboTax to calculate the effective tax rate or other factors in their calculations.

[mhotalin]

I just finished my 2023 taxes and the effective tax rate is incorrectly calculated!

My effective tax rate calculates to 6.83%, but turbotax has 6.57%?

[PaulaM]

To calculate your effective tax rate, know that marginal rates occur at different income levels. See the example of the calculation in this article. 

[mhotalin]

I did calculate it and the turbotax calculation is incorrect. Exact numbers shown below:

Total Tax/Adjusted Gross Income

$7,375/$108,025 = 0.06826 or 6.83%

Turbotax shows 6.57%