Personal Finance 101: How Tax Brackets Actually Work

Right now, with the confluence of tax season and a lot of public discussion about tax rates going forward, many people are discussing the ins and outs of how taxes work in the United States. Over the last few days, I have seen several people post tax thoughts on social media and on otherwise reputable websites that represent a wildly incorrect view of how tax brackets actually work.

What follows is a simple primer on how income tax brackets work in the United States.

What Are the Current Tax Rates for Single Filers?

As of this writing, the tax rates for single filers in the United States look like this:

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 or more

The dollar amount listed is a person’s adjusted gross income, which is the amount a person actually earns in a year minus their tax deductions. For many Americans, it’s how much they earn in a year minus the standard deduction, which is $12,000 this year.

So, let’s say you earned $30,000 this year and then took the standard deduction. Your income for the purposes of calculating taxes is $18,000.

We’ll stick with the rates for single filers as an example, just so everything is incredibly clear.

Often, each of those levels is known as a “tax bracket.” So, someone making $120,000 a year might be described as being in the 24% “tax bracket.” However, being in the 24% “tax bracket” does not mean that you’re paying 24% of your income in income taxes. That is a huge misunderstanding.

The Water Fountain Model

The mental model that works best for me is visualizing tax brackets as one of those large fancy tiered water fountains, where the top part of the fountain is small, the next part is a little bigger, and the next part is a little bigger than that, and so on.

With such a fountain, when the top portion fills up with water, it overflows, and the water overflow is caught by the next portion of the fountain. Eventually, that portion overflows, causing the portion below it to start filling with water.

That’s the way income taxes actually work. You start dumping income into the top bracket – the 10% bracket – and that’s the tax rate you pay until that bracket overflows. You keep pouring your income in, but now it goes into the 12% bracket and that’s the rate you pay until that bracket overflows. You keep pouring income in, but now it goes into the 22% bracket and that’s the rate you pay until that bracket overflows, and so on.

Even if you end up dumping money into the 24% or the 35% bracket or whatever, you still have some of your income sitting in that 10% bracket and that 12% bracket, and that’s all you pay for those portions of your income. Just because your income overflowed that lower tax bracket doesn’t mean that you suddenly have to pay more on the portion of your income that was in that bracket.

In other words, you break your income up into pieces that are equal in size to each tax bracket. When you earn more income, all you do is make the piece in the highest tax bracket bigger – you don’t change any of the others. If that piece gets bigger than that bracket, then you start another piece in the next bracket up.

A Real Example

Let’s jump into a real world example here. Let’s say Connie, a single woman, made $100,000. She does her taxes and takes the standard deduction, knocking $12,000 off of her total. She’s taxed on $88,000 of her income.

Here are the relevant rows of that income tax table from earlier in the article:

10%: $0 to $9,525
12%: $9,526 to $38,700
22%: $38,701 to $82,500
24%: $82,501 to $157,500

Many people make the mistake of assuming that Connie will be paying 24% of her income in taxes, but that’s not remotely true. Here’s how it actually works.

On her income up to $9,525, Connie is going to pay 10% in taxes – $952.50. That leaves her with $78,475 in taxable income, but now the 10% bracket is full, so we move up.

On her income between $9,526 and $38,700 – or, in another way of looking at it, the next $29,175 in income she earned that year – Connie is going to pay 12% in taxes. That equals $3,501 in taxes. That leaves her with $49,300 in taxable income, but now the 12% bracket is full, so we move up.

On her income between $38,701 and $82,500 – or, in another way of looking at it, the next $43,800 in income she earned that year – Connie is going to pay 22% in taxes. That equals $9,636 in taxes. That leaves her with $5,500 in taxable income, but now the 22% bracket is full, so we move up.

On her income between $82,501 and $157,500 – or, in another way of looking at it, the next $75,000 in income she earned that year – Connie is going to pay 24% in taxes. However, she isn’t filling up that full bracket. She only has $5,500 of her income in that range. So, her taxes on that last $5,500 is $1,320.

So, her tax total is:
$952.50 from the 10% tax bracket, plus
$3,501 from the 12% tax bracket, plus
$9,636 from the 22% tax bracket, plus
$1,320 from the 24% tax bracket.

The sum total of Connie’s taxes is $15,409.50.

Now, notice that total is not 24% of her income. If she were truly paying 24% of her income in income taxes, her total tax bill would be $24,000. Instead, it’s $15,409.50. Connie is in the 24% tax bracket, but her actual effective tax rate is only 15.4%.

If Connie were to have earned more than $100,000, then all of that additional money would have been taxed at 24%, but that’s not what she’s actually paying on her income.

For example, if Connie had earned $110,000 this year instead of $100,000, her total tax bill would have been $15,409.50 plus $2,400, or $17,809.50. Connie’s effective tax rate would go up a little – she’s now paying $17,809.50 on a total income of $110,000, or 16.2% – but she’s still not paying anywhere near 24% of her income in income taxes.

Even if Connie had a huge increase in salary – bumping her up to $200,000 a year – she would edge into that 32% tax bracket, but her overall tax rate wouldn’t be 32%. Rather, her income tax would be
$952.50 from the 10% tax bracket, plus
$3,501 from the 12% tax bracket, plus
$9,636 from the 22% tax bracket, plus
$18,000 from the 24% tax bracket, plus
$13,600 from the 32% tax bracket.

That would give Connie a total of $41,849.50 in taxes on a $200,000 income, or a 20.9% effective tax rate. Connie might be in the 32% tax bracket, but she’s only paying 20.9% of her income in taxes.

Some Takeaway Thoughts

First of all, the idea that earning more will somehow “cost you money” is foolish. The more you earn, the more you keep. Every single additional dollar that you earn, you’ll keep some large portion of it, regardless of your total earnings.

Many people and many otherwise accurate articles misrepresent this idea. They paint the picture that if you cross the line into the next tax bracket, you’ll suddenly have to pay more taxes on all of your income, so, under this misunderstanding, earning a little more if you’re close to the line can cost you money. That is completely false – earning more money always means more money in your pocket.

What the tax brackets are actually telling you is how much comes out of each dollar that you earn. For the first $9,525 you earn, only 10% comes out of each dollar no matter how much you make in total. That statement remains true regardless of whether you’re earning $15,000 a year or $1.5 million a year. For the next $29,175 you earn, only 12% comes out of each dollar no matter how much you make in total. Again, this statement remains true regardless of whether you’re earning $15,000 a year or $1.5 million a year.

Even if the highest income tax bracket were paying a rate of 70%, a proposal that’s making the rounds these days, you would still only pay a 10% tax rate on the first $9,525 you earn, regardless of how much you earned in total. You just pay the 10% on that part, then forget about it and only worry about taxes on the rest.

Another thing worth noting: the average American household income is around $70,000. If you’re a single person making $70,000 a year, you’re only in the 22% tax bracket and your effective income tax rate is somewhere around 11%. Most tax changes will have very little impact on your life.

If you’re earning $70,000 a year and the 22% tax bracket became a 25% tax bracket, it would literally only add $939 to your total tax bill. That would be about $18 from every paycheck, assuming you’re paid every other week. It would not eat 3% of your income – rather, it would eat about 1.3%.

Thus, I would encourage most Americans to not worry too much about changes to income tax laws. The only changes that will affect most Americans are adjustments to the lowest tax brackets, and those rarely change at all. They might dip up or down a percentage point or two, but those amount to just a few bucks in the paycheck of the average American household.

A final note: be very wary of absurd financial claims that don’t pass the common sense test. If someone is claiming that earning more money will actually somehow cost you money, that should fail the common sense test – and it does, because that’s not how tax brackets work. If someone is claiming that a tax change will cost you thousands, it might if you’ve got a huge income, but for most Americans, tax changes rarely have that much of an impact – it’s usually in the realm of a few dollars in your paycheck.

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