How Your Tax Rate Is Actually Calculated

Calculating your personal tax rate is a multi-step process. To find the actual percentage of income you pay in taxes, you must understand how your total income, various deductions, and available credits interact to determine your final tax liability. This process accounts for individual circumstances, from retirement savings to educational expenses, before arriving at a final tax amount.

Determining Your Taxable Income

The journey to your tax rate begins with calculating your gross income, which is the sum of all money you receive during a year. This includes sources like wages from a Form W-2, earnings from freelance work reported on Form 1099-NEC, and other financial inflows. Other examples include investment returns, such as interest, dividends, and capital gains, as well as unemployment compensation and certain retirement distributions.

From gross income, you subtract specific “above-the-line” deductions to arrive at your Adjusted Gross Income (AGI). These adjustments reduce your income before you apply the standard or itemized deductions. Examples of these adjustments include contributions to a traditional Individual Retirement Arrangement (IRA), student loan interest, and contributions to a Health Savings Account (HSA). AGI is an important figure, as it is used to determine eligibility for certain other deductions and credits.

Once AGI is established, you must decide whether to take the standard deduction or to itemize deductions. The standard deduction is a fixed dollar amount that you subtract from your AGI, with the amount varying based on your filing status. For tax year 2025, the standard deduction for a single individual is $15,000, and for married couples filing jointly, it is $30,000. Most taxpayers choose this option due to its simplicity.

Alternatively, you can itemize deductions if the total of your specific deductible expenses exceeds your available standard deduction. Common itemized deductions include:

• Mortgage interest on a primary residence
• State and local taxes (SALT) up to a combined limit of $10,000 per household
• Charitable contributions
• Medical expenses that exceed 7.5% of your AGI

After subtracting either the standard deduction or your total itemized deductions from your AGI, you are left with your taxable income.

Applying Tax Brackets to Calculate Initial Tax

With your taxable income determined, the next step is to apply the federal income tax brackets. The United States uses a progressive tax system, which means that as your income increases, you move into higher tax brackets. You only pay the higher rate on the portion of your income that falls within that specific bracket. Every taxpayer pays the same low rate on their first dollars of taxable income, regardless of their overall earnings.

The tax rates and bracket thresholds are adjusted annually for inflation. For tax year 2025, the rates are:

• 10%
• 12%
• 22%
• 24%
• 32%
• 35%
• 37%

A single filer in 2025 will pay 10% on taxable income up to $11,925. They will then pay 12% on the portion of their income from $11,926 up to $48,475, and 22% on the portion from $48,476 up to $103,350, and so on.

To see this in action, consider a single individual with a taxable income of $60,000 for tax year 2025. The calculation is broken down by bracket: the first $11,925 is taxed at 10% ($1,192.50). The next segment of income from $11,926 to $48,475 (a total of $36,549) is taxed at 12% ($4,385.88). The final portion of their income from $48,476 to $60,000 (a total of $11,524) is taxed at 22% ($2,535.28).

Summing these amounts gives you the initial tax liability before any credits are applied. In this example, the total would be $1,192.50 + $4,385.88 + $2,535.28, which equals an initial tax of $8,113.66. This figure represents the tax owed based solely on income and deductions.

Reducing Tax Liability with Credits

After calculating your initial tax liability, the next step involves applying tax credits. While deductions reduce your taxable income, tax credits provide a direct, dollar-for-dollar reduction of the tax you owe. A $1,000 tax credit reduces your tax bill by the full $1,000, making credits more impactful than a deduction of the same amount.

Tax credits fall into two main categories: nonrefundable and refundable. A nonrefundable credit can lower your tax liability to zero, but you do not receive any of the leftover credit amount as a refund. For instance, if you owe $800 in taxes and have a $1,000 nonrefundable credit, your tax bill is eliminated, but the remaining $200 of the credit is forfeited. A refundable credit is treated as a payment; if the credit is larger than your tax liability, the difference is paid to you as a refund.

Several common federal tax credits can lower a taxpayer’s final bill. The Child Tax Credit is worth up to $2,000 per qualifying child, and a portion of this credit is refundable through the Additional Child Tax Credit (ACTC). Another valuable credit is the American Opportunity Tax Credit (AOTC), which helps with higher education costs and offers a credit of up to $2,500, with 40% (or $1,000) being refundable.

Continuing the previous example, if the individual with an initial tax liability of $8,113.66 qualifies for a $2,500 nonrefundable tax credit, their final tax bill would be reduced to $5,613.66. If that credit were fully refundable and their tax liability was only $2,000, they would not only have their tax eliminated but would also receive a $500 refund.

Calculating Your Final Tax Rates

After navigating through income, deductions, and credits to find your final tax liability, you can calculate the tax rates that define your tax burden. The two most significant rates are the marginal tax rate and the effective tax rate.

Marginal Tax Rate

Your marginal tax rate is the rate you would pay on the next dollar of income you earn. It corresponds to the highest tax bracket your taxable income falls into. For the individual in our running example with a taxable income of $60,000, their income falls into the 22% bracket for the 2025 tax year. Therefore, their marginal tax rate is 22%. This rate is useful for financial planning, as it shows how much tax you will pay on any additional earnings.

Effective Tax Rate

The effective tax rate represents the actual percentage of your total income that you paid in taxes. The calculation is straightforward: divide your total tax liability by your total income or AGI. Using the ongoing example, the individual’s final tax liability was $5,613.66 after applying a credit. If we assume their AGI was $75,000 (before the $15,000 standard deduction), their effective tax rate would be approximately 7.5% ($5,613.66 divided by $75,000). This rate is almost always lower than the marginal rate.