Every dollar counts when you’re running a small business. But how much of your income really goes to taxes? Many taxpayers and business owners focus on their federal tax brackets without understanding their effective tax rates. That’s a mistake. 

Your marginal tax rate might look scary, but your effective tax rate tells the real story. It shows the true percentage of your taxable income that goes to federal income taxes. 

So, what is the effective tax rate? Here’s what to know and what this key concept means for your business. 

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Understanding the Effective Tax Rate 

Business taxes are like a ladder. Many business owners see how high it goes and get nervous. But they’re forgetting that most of their income stays on the lower rungs. 

Small business income usually flows through to your personal tax return. That’s where effective tax rates make an entrance. They reveal what percentage of your income goes to the IRS.  

While your income tax bracket might say 32%, you’ll probably end up paying less than that overall. That’s because federal income tax rates apply step by step, not all at once. We’ll cover that in the next section. 

Understanding your effective tax rate opens doors to smarter tax planning. With the correct deductions, you can lower your taxable income significantly.  

Timing your business expenses strategically helps, too. Every decision adds up to reduce your overall tax liability and keep your effective tax rate in check, all while staying fully compliant with federal income tax requirements. 

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Effective Tax Rate Versus Marginal Tax Rate 

When you’re running a business, understanding your liability as a taxpayer means knowing both your marginal and effective tax rates. These two income tax rates tell very different tales about what taxpayers owe. 

Your marginal tax rate is set by the last dollar you earn and the tax percentage bracket it falls within. That’s because the US uses a progressive system of federal income tax brackets for filers’ personal returns.  

If you earn $90,000, your marginal tax rate would be 22%. However, the majority of your salary is taxed at a lower percentage.  

This system applies to your business income when it flows through to your personal return, which is the case for most business structures small businesses are likely to use. 

Let’s see how it works for Sarah, who owns a web design studio that generated $150,000 in taxable income. This income puts her in the 24% tax bracket on her personal return. But that doesn’t mean she’s paying 24% on all her business income.  

Instead, her federal income tax rates work like this: 

• 10% on the first $11,925 
• 12% on income from $11,925 to $48,475 
• 22% on income from $48,475 to $103,350 
• 24% on the remaining income up to $150,000 

These income tax brackets for the 2025 tax year determine how much Sarah pays the IRS at each level.  

Sarah’s effective tax rate is the average tax rate across all her taxable income. It will be much lower than her 24% marginal tax rate. 

This is crucial knowledge for growing your business. Some business owners avoid expanding because they worry about hitting higher tax brackets. However, understanding how marginal income tax rates actually work shows that higher income doesn’t mean all your profits will get eaten up if you graduate to a higher taxpayer bracket. 

How To Calculate the Effective Tax Rate 

So, what’s your effective tax rate? Fortunately, the formula is a piece of cake. Just take your total federal income tax paid and divide it by your taxable income. Multiply by 100 to get a percentage, and you’ve got your effective tax rate: 

Effective Tax Rate = (Total Federal Income Tax / Taxable Income) × 100 

Let’s return to Sarah’s web design studio with $150,000 in taxable income. Here’s how her tax calculation breaks down on her personal return: 

• First $11,925: $1,192.50 (10% tax bracket) 
• $11,925 to $48,475: $4,386 (12% tax bracket) 
• $48,475 to $103,350: $12,072.50 (22% tax bracket) 
• $103,350 to $150,000: $11,196 (24% tax bracket) 

Adding it all up, Sarah’s total federal income tax comes to $28,847. To find her effective tax rate, she divides this by her taxable income of $150,000: 

$28,847 / $150,000 = about 0.192, or 19.2% 

This calculation helps you predict your quarterly tax payments and avoid penalties. It also helps you measure how deductions and business expenses affect your tax liability.  

That’s why it’s vital to know as your business grows. You can plan ahead and make sure you know how much you have to pay in taxes. 

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How To Calculate the Marginal Tax Rate 

Finding your effective tax rate is easy, but finding your marginal tax rate is even easier. Just find where your highest dollar of income falls in the federal tax brackets.  

For 2025, these are the tax brackets for income on personal returns, according to Investopedia: 

• 37% for incomes over $626,350 ($751,600  for married couples filing jointly) 
• 35% for incomes over $250,525 ($501,050 for married couples filing jointly) 
• 32% for incomes over $197,300 ($394,600 for married couples filing jointly) 
• 24% for incomes over $103,350 ($206,700 for married couples filing jointly) 
• 22% for incomes over $48,475 ($96,950 for married couples filing jointly) 
• 12% for incomes over $11,925 ($23,850 for married couples filing jointly) 
• 10% for incomes $11,925 or less ($23,850 or less for married couples filing jointly) 

Let’s look at Sarah’s web design studio again. Her taxable income of $150,000 falls into the 24% bracket. That’s her marginal tax rate. She’ll pay 24% on any additional income until she reaches the next bracket at $197,300.  

Like effective tax rates, marginal tax rates help with key business decisions. When considering new projects or expansion plans, you know exactly what percentage of that additional income goes to the IRS.  

Many business owners find they have more room to grow than they thought since only the new income falls into their highest tax bracket. 

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6 Tax Tips for Small Business Owners 

Understanding your marginal and effective tax rates is just the beginning. Effective tax planning helps lower your taxable income and reduces your overall liability. Here are six proven strategies successful business owners use to manage effective tax rates: 

1. Separate Your Accounts. Every taxpayer’s first step toward lower effective tax rates is good organization. Keep your business income and expenses separate from your personal finances. This makes it easier to track deductions and calculate your tax liability. It also helps prevent missing valuable business deductions that could lower your effective tax rate. 
2. Time Your Income Strategically. As a taxpayer, sometimes the date you receive income matters just as much as the amount. By holding over some income and expenses to next year, you might be able to keep more in lower tax brackets. This strategy works especially well for filers near the edge of a higher tax bracket. 
3. Master Your Deductions. Many filers in higher tax brackets miss opportunities to reduce their effective tax rate. Common business deductions include office space, equipment, travel expenses, and professional development. Track these deductions carefully. They directly impact your effective tax rate and can even lower your marginal tax rate by reducing your total taxable income. 
4. Document Every Expense. Rock-solid documentation is as important as it’s ever been. Every business expense you track could be a deduction that reduces your effective tax rate. A software tool like Invoice Simple’s Business Expense Tracker simplifies the process. It lets you scan receipts to create expenses and keeps track of your records to make tax reporting a breeze. 
5. Consider Professional Guidance. As your business income grows, so does the complexity of your taxes. A tax professional can often find enough deductions to cover their fee and then some. They’ll help you understand both your marginal tax rate and effective tax rate while planning for future tax years. 
6. Stay Informed About Changes. Federal tax brackets change every year for inflation. Savvy taxpayers plan ahead for these changes, adjusting their strategies to minimize their effective tax rates over time. 

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Key Takeaways for Effective Tax Rate 

• Marginal tax rate is determined by the highest tax bracket your income falls within. 
• Effective tax rate is the actual percentage you pay on your taxable income.  
• You can calculate your effective tax rate with this formula: (Total Federal Income Tax / Taxable Income) × 100 
• You can use deductibles to lower your effective tax rate. Software tools like a business expense tracker to simplify tracking expenses for deductions. 
• Consider working with a tax professional to maximize your business tax strategy.  

Simplify Tax Season With Invoice Simple 

Managing your effective tax rate starts with managing your finances. And that starts with Invoice Simple. 

Get notified when your invoices are read and track when they’re due. Keep a record of clients and track your monthly income with built-in reporting that can easily be shared with your accountant. Manage all your finances in one place with Invoice Simple. 

Simplify Tax Season