Don’t Fear The Higher Tax Bracket (Or Why A Reader Needs More Cowbell)

One of my readers, Annie, writes:

I am up for a promotion at work, but a coworker says that I shouldn’t try to get the job because it will put me in a higher tax bracket. Is this something I should worry about? Would I actually make less money after getting a raise?

Don’t sweat the small stuff, Annie, and go for the promotion. You will bring home more money after getting promoted, even if it does bump you into another tax bracket. Your coworker is either misinformed or is trying to convince you not to go for the promotion. Here’s why.

A Quick Primer on Tax Brackets

At the end of the year, when you do your taxes, you’re actually calculating a number called your taxable income. This is the amount of income you brought in that the government actually takes income tax out of. The higher that number, the higher tax bracket you find yourself in.

For example, let’s say you’re a single person. In 2006, the United States federal tax brackets were:
10%: from $0 to $7,550
15%: from $7,551 to $30,650
25%: from $30,651 to $74,200
28%: from $74,201 to $154,800
33%: from $154,801 to $336,550
35%: $336,551 and above

If you make $50,000 in taxable income, then $7,550 is taxed at 10%, $23,100 is taxed at 15%, and the rest, $19,350, is taxed at 25%. That means you pay a total of $9,057.50 in income tax. $40,942.50 is yours to keep.

Now, if you got a raise and made $60,000 in taxable income, then $7,550 is taxed at 10%, $23,100 is taxed at 15%, and the rest, $29,350, is taxed at 25%. Notice that there’s only one difference here: that extra $10,000 is taxed at the 25% rate, but nothing else changes. You pay a total of $11,557.50 in income tax, and $48,442.50 is yours to keep. Your raise, after taxes, is $7,500.

Understanding tax brackets can explain a few things:

Tax deductions are more lucrative for high income people than low income people. If you only have $30,000 in taxable income, you’re only paying 15% at most on your income, so sweating it out for a $2,000 deduction saves you only $300. However, if you’re in the 35% bracket, that same $2,000 deduction saves you $700. That’s a $400 difference, so the higher income people generally get more benefit from deductions.

Tax withholdings from your paycheck are based on your pay rates and the tax brackets. This information is usually supplied by the IRS and is based on your salary and the number of dependents you claim (which are deductions). This gives a thumbnail of what you’ll be taxed on so your employer can keep out an appropriate amount of money. Altering your number of deductions changes the size of the withholdings because if you claim fewer dependents, your taxable income appears to go up, and if you claim more dependents, your taxable income appears to go down.

“Extra” income is always taxed at the highest rate. Let’s say you’re in the 28% tax bracket and you happen to make an extra thousand dollars doing some consulting work. That money is taxed at 28%, so you’d better be saving 28% of it for tax day. This is often why people end up paying more on their taxes come April – they earned some extra income.

To summarize, Annie, don’t fear the tax bracket – more earnings are always better.

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  1. Jamie says:

    But wait! Don’t forget that your marginal tax rate determines your long term capital gains. Let’s say you are single and make $40k. If you contribute $10k to your Traditional 401k plan, you skate into the 15% bracket, and thus cement the low end of the capital gains (5% in ’06 as opposed to 15%). So, throw in a big raise, and you’ll be stuck at the higher capital gains right. Am I wrong?

  2. William says:

    I looked at your tax brackets. Here are ours in Canada.

    * 0% : on taxable income of $7999.00 or less
    * 15.25%: on taxable income of $36,378 or less
    * 22%: on taxable income of more than $36,378, but not more than $72,756
    * 26%: on taxable income of more than $72,756, but not more than $118,285
    * 29%: on taxable income of more than $118,285

    But the Province could also take a portion. Up to 15% I think. Alberta has a flat rate of 10%.

  3. Tony says:

    Excellent post!!! I had no idea that, that is how the tax brackets work. I thought if you got bumped up to a higher bracket that your entire income was taxed at that rate. Guess you learn something new everyday.

  4. jake says:

    I am a bit confuse. Maybe I miss read these numbers. I thought that the brackets always meant that lets say you make $50,000 and from your 2006 income bracket list, you would fall into the 25% bracket because you made between $30,651 to $74,200. so (.25)(50,000)= $12,500 taxed, leaving you with $37,500.

    I did not know that they actually chop your income into parts or am I missing something?

  5. Jim Lippard says:

    Jake: Trent explained it correctly. The first dollars you earn are taxed at the lowest bracket, until you reach the dollar limit for that bracket. It’s not the case that your entire income is taxed at the highest marginal rate based on the total.

    Jamie: Yes, your long-term capital gains tax rate is dependent on your income tax bracket–5% if you’re in the 10% or 15% bracket, 15% if you’re in the 25%, 28%, 33%, or 35% brackets. Your scenario is right (though you can contribute up to $15,500 to your 401K, and another $4,000 to an IRA, which will reduce your AGI more than in your example).

  6. HappyRock says:

    Nice post Trent. I think many people misunderstand how the tax brackets works. Most people this it is one rate for all of your money.

  7. Amy says:

    What about the AMT? My understanding is that it limits your ability to take some deductions, meaning that you just bump over that threshold, you could end up taking home less money.

  8. Camille says:

    One other thing Annie might like to think about – if her employer offers a pre-tax retirement fund, then she can put some of that raise away. Pay a bit more in tax, Annie, and save a bit of your raise, and you’ll be helping yourself get into a better financial position!

    P.S. One guideline I use is to increase my retirement savings by 2% each time I get a raise… may not seem like much, but I work for a state agency, so my raises are usually only an increase of 3-5%.

  9. Tony says:

    Nice post, but I’m curious to one thing. This applies to both examples, but using the $50,000 example, how did he acquire the numbers used for taxing? Of course, I knew where he got “$7,550″ for the first bracket. But how did he arrive at “$23,100″ for the second number for the second tax bracket?

    Any help would be appreciated.

    Thanks.

  10. Tyler says:

    I found this to be an extremely informative post on something that I have never had explained to me clearly. Thanks for clearing things up.

  11. Rick says:

    Tony: That’s the difference between the 30,650 break and the 7550 break. In other words, the first $7550 of income is taxed at 10%. The next $23100 of income (meaning a total of $30650) is taxed at 15%.

    The concept is called your marginal tax rate. Even though you might be in the 25% tax bracket, this does not mean your income is taxed at 25%. It does mean that any *additional* income is taxed at 25%. So in Trent’s example, the person is in the 25% tax bracket, but his effective tax rate is only about 18%.

  12. Jim Lippard says:

    Amy: The AMT is like a whole alternative tax system, which isn’t merely a factor of how much money you make. When AMT kicks in, it limits your ability to take certain kinds of deductions (and your exemptions), and they get added back into your income for calculation of AMT. If you are going to get hit by AMT in a given year, it usually turns out to be better to reverse your normal tax strategies, by incurring more income and deferring deductions, rather than deferring income and using as many deductions as possible, because the AMT tax rate is either 26% or a maximum of 28% (versus a max of 35% for the regular tax rate).

    AMT is beyond the scope of Trent’s comment on this subject, but you can find an excellent primer on AMT at Fairmark’s website.

    I’ve only been hit by AMT once, due to the exercise of incentive stock options. It was an enormous pain, but the long-term effects washed out (aside from the additional effort in doing my taxes!) because I ended up taking a gigantic AMT loss on that stock (a “dot-bomb”), which gave me several years of the maximum capital loss (due to AMT credit).

  13. Michelle says:

    I was recently looking for information on California’s state tax rates. The verbiage I found made it sound like their rates are *not* marginal rates but apply to the entire income. Does anyone here know for sure, one way or the other?

    (I do understand how marginal tax rates work. I use a spreadsheet every year to compute my expected taxes, based on my primary salary plus secondary income, so that I can get my withholding right.)

  14. Nicole says:

    Okay, so does this mean Annie’s net will be lower but she’ll get more back at the end of the year?

  15. Tobias says:

    If you want to find the updated numbers for 2007, you can find them on the IRS site here:

    http://www.irs.gov/pub/irs-pdf/f1040es.pdf

    Other numbers of interest are the standard deduction will be $5350 for single, $7850 for HoH, and $10,700 for married filing jointly.

    I just took my last paycheck and did my estimated taxes in around 10 minutes. This article definitely helped to explain what I saw. As I’ve gotten raises over the years I’ve noticed a continual decrease in the size of my tax return. This year due to our company being bought out and all our stock options being forcefully cashed out, many received some large checks. For me, it looks like I found the ‘sweet spot’ and my return will be very close to 0. (single taking the standard deduction) I guess there will be no tax-time splurge this year!

    Nicole, I think the calculations imply that Annie’s net will be higher and her return will be lower (assuming her dependents and the like stay the same). She will pay more of her total income than she did at the 25% rate, but her take-home income will increase by 75% of the amount of the raise. (less all the other withholding stuff)

    The reason for the smaller return (as in my case, although this is only a guess, but it would explain the numbers) is that your withholding is a constant percentage (at least it is for me, looking at one paycheck from 2005 and one from today). So if Annie is withholding at 19% (probably unlikely, just used because it makes the example easier to understand) she will end up with a refund of $442.50 before her raise. After her raise she will owe the IRS $157.50. If I understand correctly, the difference is that her withholding remains the same while her marginal rate increases. However, her take-home pay is increasing by much more than the $600 swing her tax return is showing.

    Thanks, good post!

  16. Tobias says:

    Lol, see what happens when you resurrect old posts. Poor Nicole posted her reply in July, and I replied in September…=)

  17. cindy says:

    what about life insurance as a retirememt spot no tax in no tax out transfer to child tax free one author three books still chance to become millionare or something like that

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