When it comes to taxes, terminology can cause a lot of confusion. Gross income, AGI, taxable income, marginal and average tax rates —it’s easy to get lost in the lingo. But understanding these terms can make a big difference in how you view your taxes and how you plan your finances. Let’s decode them in plain English.
Gross Income vs. Adjusted Gross Income (AGI) vs. Taxable Income
First up is gross income. It is all the money you earn in a year before any deductions. Think of it as how much you made in total. Gross income includes wages, salary, bonuses, tips, investment income, and even side gig earnings. It’s everything before the government takes their cut and you apply deductions.
However gross income isn’t the number the IRS uses to figure out your taxable income. That’s where Adjusted Gross Income (AGI) plays its part. AGI is like gross income’s more refined cousin. You take your gross income and subtract certain adjustments. These adjustments include contributions to a retirement account (like a traditional IRA), student loan interest, charitable contributions, and sometimes health insurance premiums if you’re self-employed. The result after all those deductions? Your AGI.
Your AGI is a crucial number because certain tax benefits are based on it. It is the figure that tax preparers use as the foundation for many tax calculations. Certain credits and deductions, like the earned income tax credit, are only available if your AGI is below a specific limit. Others are based on a percentage of your AGI. For instance, a person can itemize and deduct qualified healthcare expenses that cannot be reimbursed and surpass 7.5% of their AGI. So, while gross income tells you what you earned, AGI is the basis for calculating many deductions and credits.1
Once you’ve nailed down your AGI, you can then subtract either the standard deduction or itemized deductions (depending on which is applicable to your situation). The result is your taxable income, and this is the number on which you will be paying taxes.
Marginal Tax Rate vs. Average Tax Rate
Now, let’s move on to tax rates—specifically, the marginal tax rate and average tax rate. These are two more terms that sound similar but have different meanings.
Your marginal tax rate is the tax rate you pay on your last dollar of income. The U.S. tax system is progressive, meaning that as your income goes up, it gets taxed in chunks, and those chunks are taxed at different rates. For example, if you're single, your first $11,600 of taxable income might be taxed at 10%, the next chunk up to $47,150 at 12%, and so on, up to the highest bracket. The marginal tax rate is whatever rate applies to your last chunk of income. So, if your taxable income is $60,000, your marginal tax rate would be 22% because that’s the rate applied to the top portion of your earnings in the current tax bracket system. It’s not the rate you pay on all your income, just the last part of it.2
On the flip side, your average tax rate is the total amount of tax you pay as a percentage of your total income. People often get confused on this point. For example, if you’re in the 22% marginal tax bracket, you might think you’re paying 22% on everything you earn. But that’s not the case. Remember, your income is taxed progressively. So, only the last portion of your income is taxed at 22%, while the earlier portions are taxed at lower rates. Your average tax rate takes all those rates into account and tells you what percentage of your total income went to taxes.3
Let’s say your taxable income is $60,000. If you paid $7,000 in taxes, your average tax rate would be around 11.6%. Even though your marginal tax rate is 22%, you don’t pay 22% on every dollar, so your average tax rate will almost always be lower than your marginal rate.4
Why It Matters
Understanding the difference between gross income, AGI and taxable income, can help you plan your finances, particularly when it comes to deductions that may lower your tax liability. Meanwhile, knowing the distinction between your marginal and average tax rates can give you a better idea of how much tax you’re really paying versus what tax brackets might make it seem like you’re paying.
Taxes can leave you scratching your head. But when tax season rolls around, comprehending the tax concepts in this article can make your financial picture clearer—and maybe even save you some money.
Sources:
1 https://www.nerdwallet.com/article/taxes/adjusted-gross-income-agi
² Tax Foundation, “2024 Tax Brackets.”
3 FedSmith, “Marginal vs. Effective Tax Rates — How Are They Different?” July 7, 2021, by Neal Smith
4 Investopedia, “Marginal vs. Effective Tax Rates.”
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