How many times have you heard someone worry about a raise or a bonus because it “pushes me into a higher tax bracket?” Maybe you’ve even worried about this yourself? Well, time to breathe easy. The US income tax system is a marginal system. That means that the effective percentage you owe is not the same as the tax bracket you’re in. Instead, only the incomes that fall within a given bracket’s range is taxed at that bracket’s percentage.
Let’s break it down with some numbers.
Meet Jane.
Jane will be our hypothetical income tax payer for this example. She has been working at a marketing firm for the past five years, ever since she was in college. She started as an intern, and has been working her way up the ranks. Last year, she earned a total of $48,500. After the standard deduction, plus the deductions she can take for her student loan interest, her taxable income was $34,500.
This year, Jane’s hard work has paid off. Her employer has offered her a promotion to a salaried position with more responsibility and a nice raise to compensate. Her new yearly income will be $52,760. That’s an extra $4260 a year. She’s excited at first, until a friend mentions that this will change her tax bracket.
Jane and her friend look at a tax-bracket chart, and this is what they see:
2018 Tax Brackets
| 10% | $0 to $9,525 |
| 12% | $9,526 to $38,700 |
| 22% | $38,701 to $82,500 |
| 24% | $82,501 to $157,500 |
| 32% | $157,501 to $200,000 |
| 35% | $200,001 to $500,000 |
| 37% | $500,001 and up |
How she thinks it works:
Before her raise, Jane thinks of herself as being in the second tax bracket. She didn’t pay much attention to the specific percentage of her income that she paid in taxes last year (she trusted an online tax preparation service to handle the details). She assumes based on her tax bracket that it was 12% of her $33,500 taxable income, which would be $4020. That would leave her with $44,480 after taxes. (That’s her total income of $48,500 minus $4020 in taxes.)
After her raise, Jane will be earning $52,760/year, with a taxable income of $38,760. This puts her right at the bottom end of the 22% tax bracket. Jane is frustrated because it appears that she’ll have to pay an extra 10% of her taxable income after only just barely making it into that next tax bracket. It’s an understandable frustration. If that were how tax brackets worked, she’d now be on the hook for $8527.20 in income tax. That would leave her with $44,232.80 after taxes.
Who sees what’s wrong with this picture? Who wants to take on extra responsibility and more hours (without overtime) only to be “compensated” be a take-home decrease of about $250? Not Jane!
Fortunately for her, Jane Googled “how tax brackets work” before turning down the promotion.
How it really works:
What Jane found out was that a given tax bracket’s percentage only applies to income that falls within that bracket. This means that the first $9,525 of her income is taxed at 10%. Then, any amount that she makes between 9,526 and 38,700 is taxed at 12%, and so on.
That means that since Jane is only $60 into the 22% tax bracket, only that $60 is taxed at 22%.
Whew! What a relief! Let’s take another look at Jane’s numbers and find out what she’ll really owe:
Before her raise:
Total income: $48,500
Taxable income: $33,500
- First bracket income tax: $952.50
(10% of the full $9,525 in that bracket) - Second bracket income tax: $2877
(12% of the amount over $9,525)
Total income tax owed: $3829.50
Effective tax rate: 11.4%
(tax paid divided by taxable income)
Total pay after taxes: $44670.50
After her raise:
Total income: $52,760
Taxable income: $38,760
- First bracket income tax: $952.50
(10% of the full $9,525 in that bracket) - Second bracket income tax: $3501
(12% of the full $29,175 in that bracket) - Third bracket income tax: $13.20
(22% of the amount over $38,700)
Total income tax owed: $4466.70
Effective tax rate: 11.5%
(tax paid divided by taxable income)
Total pay after taxes: $48293.30
After her raise, Jane’s effective tax rate only goes up by one-tenth of a percentage point. Her total after-tax income goes up by $3,623. So yes, it’s a real raise after all. Now, whether it’s worth the additional responsibility of her new position? We’ll have to leave that up to Jane.
When it DOES matter:
If you are underemployed and concerned about getting government assistance such as Medicaid or SNAP, then you may find yourself in a situation where a small raise that puts you over the eligibility threshold DOES negatively impact your finances. There is a gap between what the government thinks is a living wage, and what it really takes to get by in most places in the US. But that’s another story for another time…
