## Calculating Effective Tax Rate

Non-investing personal finance issues including insurance, credit, real estate, taxes, employment and legal issues such as trusts and wills
WestTechsan
Posts: 19
Joined: Tue Apr 12, 2016 11:00 am

### Calculating Effective Tax Rate

This has probably been discussed before, but what is the more common/preferred method of calculating one's effective tax rate, tax owed divided by gross income, or tax owed divided by taxable income?

weedf16
Posts: 65
Joined: Tue Apr 14, 2015 12:16 pm

### Re: Calculating Effective Tax Rate

WestTechsan wrote:tax owed divided by gross income
This.

dbr
Posts: 27207
Joined: Sun Mar 04, 2007 9:50 am

### Re: Calculating Effective Tax Rate

Appeal to authority for definitions:

http://www.investopedia.com/terms/e/eff ... axrate.asp

It is an excercise for readers to decide if all published examples are mutually consistent.

Examples of possible debate are including tax deferred income in income, including value of benefits in income, etc.

As always the best answer may be "it depends" on what you want to know the number for.

WestTechsan
Posts: 19
Joined: Tue Apr 12, 2016 11:00 am

### Re: Calculating Effective Tax Rate

dbr, I posted the question because online sources identify both as the method to use. I understand it essentially boils down to what is the purpose of the calculation, my interest was piqued because I've always calculated it using gross income but got into a spirited discussion with a fellow who insists it's calculated using taxable income.

livesoft
Posts: 62838
Joined: Thu Mar 01, 2007 8:00 pm

### Re: Calculating Effective Tax Rate

Let me take this opportunity to introduce you to the Average Effective Adjusted Livesoft Tax Rate with worksheets to figure this out:
viewtopic.php?t=163748
This signature message sponsored by sscritic: Learn to fish.

Wakefield1
Posts: 866
Joined: Mon Nov 14, 2016 10:10 pm

### Re: Calculating Effective Tax Rate

total tax obligation for the taxable year,paid up as by withholdings and estimated tax payments and/or still owed as of filing,divided by gross income?
taxable income or actual income minus zero bracket amount? Zero bracket might make more sense to keep track of and varies by situation

dbr
Posts: 27207
Joined: Sun Mar 04, 2007 9:50 am

### Re: Calculating Effective Tax Rate

WestTechsan wrote:dbr, I posted the question because online sources identify both as the method to use. I understand it essentially boils down to what is the purpose of the calculation, my interest was piqued because I've always calculated it using gross income but got into a spirited discussion with a fellow who insists it's calculated using taxable income.
Well. my second reference uses taxable income and the other two use gross income. But you'll notice that second article is a discussion of the effect of a progressive tax rate calculation and the difference between marginal and "average" tax rate. That article actually only discusses corporate income and does not talk about exemptions and deductions. The third article is mainly an article about how exemptions and deductions reduce the effective rate of taxation on your gross income and, of course, computes effective tax rate from gross income.

Personally I agree that most people talking about personal income taxes would use gross income in calculating effective tax rate. Absent any specific context most people would understand that to be the meaning. However, the issue is really just one of using math to understand things about one's financial situation, so I would repeat that one does what is meaningful to the context at hand.

Also, note the first reference I listed says the income to use is earned income, which does not include, among other things, interest and dividends on investments. I doubt any of us would use that definition and yet it comes from the so-called "Investopedia."

Now I have done part of the exercise for the reader I suggested.

To be more provocative, I really do suggest people seriously consider whether or not tax deferred contributions to a 401K or IRA are part of income even if the amounts are not on a W2 and may not be entered in the tax return at all. This then opens the question of tax rate on deferred tax liabilities.

alfaspider
Posts: 1611
Joined: Wed Sep 09, 2015 4:44 pm

### Re: Calculating Effective Tax Rate

In the corporate context, there are specific rules for how a public company reports its effective tax rate. However, in the personal context it's not quite so clear.

For example, depending on how one wants to define it, gross income for this purpose may or may not include:
1) The value of non-cash benefits like health insurance
2) Pension contributions
3) 401k Match amounts
4) Unvested RSUs

I think it is most accurate to include the above. For example, person 1 may make \$200,000 straight cash with no additional benefits or compensation. Person 2 may have a salary of \$150,000, get a 10% 401k match, 10% pension contribution, and get \$20k worth of RSUs (which aren't taxed until they vest 3 years later). Person 1 and person 2 are economically in the same position (other than the fact that person 2 has more restrictions on use of the money), but Person 1 will have a much higher effective tax rate in year 1 all other things being equal (like state residence, homeownership, etc.) because much of person 2's tax liability is deferred. Person 2 will have deferred tax liabilities, but you can NPV the putative value of that deferral to show that Person 2 is effectively taxed less than person 1.

retiredjg
Posts: 34372
Joined: Thu Jan 10, 2008 12:56 pm

### Re: Calculating Effective Tax Rate

There are so many creative ways to calculate "effective tax rate" that it seems like a meaningless number to me. The only way to use this number is for all samples to be calculated the exact same way.

Quark
Posts: 1045
Joined: Sun Nov 01, 2015 5:32 pm

### Re: Calculating Effective Tax Rate

Why do you want to calculate effective tax rate? Knowing the purpose for which you're doing the calculation would help inform a useful answer.

Rodc
Posts: 13601
Joined: Tue Jun 26, 2007 9:46 am

### Re: Calculating Effective Tax Rate

Quark wrote:Why do you want to calculate effective tax rate? Knowing the purpose for which you're doing the calculation would help inform a useful answer.
+1

These questions always come down to what problem are you trying to solve.
We live a world with knowledge of the future markets has less than one significant figure. And people will still and always demand answers to three significant digits.

WestTechsan
Posts: 19
Joined: Tue Apr 12, 2016 11:00 am

### Re: Calculating Effective Tax Rate

Quark wrote:Why do you want to calculate effective tax rate? Knowing the purpose for which you're doing the calculation would help inform a useful answer.
Good point. My wife runs an MLM from the house and has had the good fortune of doing very well with it. She is considered to be one of the "top earners" with the company. We are very blessed with her success. A number of top earners started discussing their taxes this week and as can be expected, people are reporting effective tax rates across a number of ranges, running from the low end of 10% to a high end closer to 30%. Keep in mind these people have gross incomes from this business in the \$300K - \$750K+ range. A large number of them are claiming they pay 15% or less in taxes, which I believe they are basing on their gross income. For 2015 my wife and I, taking into account my salary and her income, paid an effective tax rate (on our gross income) of about 29%. I'm trying to figure out what these folks are doing to so significantly reduce their taxable income but it can be difficult to begin that discussion when some folks can't agree on whether their effective tax rate is calculated using their gross income or taxable income. So many variables can come into play in determining tax liability that it's likely a useless exercise but the side discussion of how an effective tax rate should be calculated got me sidetracked. Bottom line, I'd like to know if there is any secret sauce we can use that would reduce our taxes.

NotWhoYouThink
Posts: 2096
Joined: Fri Dec 26, 2014 4:19 pm

### Re: Calculating Effective Tax Rate

A lot of people have no idea how much tax they pay.

Do they count state taxes (if there is one in your state)? Social Security/Medicare?

Also, a lot of people lie. Or tell creative stories. Some people will tell you, in all earnestness, that their Edward Jones representative is doing a great job with their money.

Your best bet is to understand your taxes, and work to optimize the amount of earnings you keep, which is not always the same as minimizing taxes.

alexost
Posts: 116
Joined: Wed Sep 05, 2012 1:59 pm

### Re: Calculating Effective Tax Rate

How about taking last years tax returns and calculate using total taxes actually paid divided by gross income. This captures all income related taxes but not sales taxes etc.

Rodc
Posts: 13601
Joined: Tue Jun 26, 2007 9:46 am

### Re: Calculating Effective Tax Rate

WestTechsan wrote:
Quark wrote:Why do you want to calculate effective tax rate? Knowing the purpose for which you're doing the calculation would help inform a useful answer.
Good point. My wife runs an MLM from the house and has had the good fortune of doing very well with it. She is considered to be one of the "top earners" with the company. We are very blessed with her success. A number of top earners started discussing their taxes this week and as can be expected, people are reporting effective tax rates across a number of ranges, running from the low end of 10% to a high end closer to 30%. Keep in mind these people have gross incomes from this business in the \$300K - \$750K+ range. A large number of them are claiming they pay 15% or less in taxes, which I believe they are basing on their gross income. For 2015 my wife and I, taking into account my salary and her income, paid an effective tax rate (on our gross income) of about 29%. I'm trying to figure out what these folks are doing to so significantly reduce their taxable income but it can be difficult to begin that discussion when some folks can't agree on whether their effective tax rate is calculated using their gross income or taxable income. So many variables can come into play in determining tax liability that it's likely a useless exercise but the side discussion of how an effective tax rate should be calculated got me sidetracked. Bottom line, I'd like to know if there is any secret sauce we can use that would reduce our taxes.
These things often turn in to "one upsmanship games". Is the goal to claim to have the highest or lowest effective rate?

Use the method that allows you to claim the highest or lowest possible number depending on the game.

Or you can do what I usually do which is to smile and not say anything.
We live a world with knowledge of the future markets has less than one significant figure. And people will still and always demand answers to three significant digits.

livesoft
Posts: 62838
Joined: Thu Mar 01, 2007 8:00 pm

### Re: Calculating Effective Tax Rate

WestTechsan wrote:Good point. My wife runs an MLM from the house and has had the good fortune of doing very well with it. She is considered to be one of the "top earners" with the company. We are very blessed with her success. A number of top earners started discussing their taxes this week and as can be expected, people are reporting effective tax rates across a number of ranges, running from the low end of 10% to a high end closer to 30%. Keep in mind these people have gross incomes from this business in the \$300K - \$750K+ range. A large number of them are claiming they pay 15% or less in taxes, which I believe they are basing on their gross income. For 2015 my wife and I, taking into account my salary and her income, paid an effective tax rate (on our gross income) of about 29%. I'm trying to figure out what these folks are doing to so significantly reduce their taxable income but it can be difficult to begin that discussion when some folks can't agree on whether their effective tax rate is calculated using their gross income or taxable income. So many variables can come into play in determining tax liability that it's likely a useless exercise but the side discussion of how an effective tax rate should be calculated got me sidetracked. Bottom line, I'd like to know if there is any secret sauce we can use that would reduce our taxes.
This is where my link to the ALI stuff can help you. I gave a specific way to calculate the rates and people answered with that specific methodology. You can use that methodology and look at the poll results yourself.

As for reducing taxes, there are other threads on that. Here is one on how a family with about \$200,000 gross income can hardly pay any taxes: viewtopic.php?t=79510 Your family has more income, but the thread will give you some ideas about "the secret sauce." Can your spouse have her own individual 401(k)?

Also note that one can have a lower tax rate if they pay for unnecessary expenses that cost more than the taxes they save. For instance, pay an accountant \$100,000 a year to do your taxes. No worries, most of the \$100,000 is deductible.

Your family income is high and you have an effective income tax rate to match.
This signature message sponsored by sscritic: Learn to fish.

dsmil
Posts: 579
Joined: Tue Sep 08, 2009 10:51 am

### Re: Calculating Effective Tax Rate

I love seeing my effective tax rate. Most people automatically think that they are taxed at their marginal rate, but it's often not even close to that.

WestTechsan
Posts: 19
Joined: Tue Apr 12, 2016 11:00 am

### Re: Calculating Effective Tax Rate

Appreciate the info and thoughts folks. We have confidence in our current CPA but recently sought a second opinion from another well recommended CPA, he said our current guy is doing a good job and he would make little to no changes. That made my wife feel better, perhaps more confident in our current approach. I do suspect a fair amount of these top earners don't have a real good grasp of their actual effective rate, and they may also be taking a more aggressive approach to deductions than we're willing to consider. They may also be utilizing appropriate deductions that we haven't considered and we may need to take a more aggressive approach. I'll continue to look in to it.

Thanks again, this was a helpful discussion.