An Easy Explanation of Tax Brackets

Tax Brackets, Explained

Below is a question a tax professional is asked all of the time:

"I am up for a promotion at work, but maybe 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?"

The main point you should know about tax brackets: They are misleading.

In a perfect world, we would just look at your tax bracket (10%, 25%, etc), multiply that by your income, and  voilà!  You get the amount you’ll pay this year in taxes.

But it’s not that simple. (This are taxes after all. Nothing will be easy, right?) Tax brackets give you only a very general idea of how much in taxes you'll pay.

Your Marginal Tax Bracket vs. Your Effective Tax Rate

The most important thing to know is the difference between your marginal tax bracket and your effective tax rate. Think of your marginal tax bracket (your higher bracket after your promotion at work) as just one part of the equation that determines how much you pay in taxes. Think of your effective tax rate as how much you will actually pay compared to your taxable income. So if your marginal tax bracket is 15%, you could pay an effective tax rate as low as 5%. That is much more acceptable!

How It Works

Why is your effective tax rate lower? Well, first of all, you aren’t taxed on your entire income. You’re taxed on your taxable income. You can look at your tax return from last year and find the item that says “Taxable Income.” 

Once you know your taxable income and your filing status figuring out tax brackets can be easy.

The second reason why you pay less than your tax bracket says you will is that your income isn’t all taxed at the same rate. It’s taxed in chunks. It’s called a progressive tax, because the more money you make, the more you are taxed.

For Example ...

Let’s illustrate with a very simplified example: Let’s say you are a single taxpayer with a taxable income of $80,000. As you can see from the chart, you are in the 22% tax bracket. Does that mean you’re paying a quarter of your taxable income, or $20,000, to the government? No. (That sure is a relief.)

Instead, each chunk of your income that falls into a bracket is taxed at a different rate. $9,525 of your income will be taxed at a 0% rate. The next portion of the income you made between $9,525 and $38,700 will be taxed at a 12% rate. And the remaining portion that you made above $38,700 will be taxed at a 22% rate. That means that after deductions even though you are in the 22% tax bracket, you are only paying an effective tax rate of a much lower percentage. We like that much better.

Are You Afraid of a Tax Bracket?

What this also means is that if you got a raise which bumped your taxable income up to $90,000, your taxes won't suddenly skyrocket. Only the income you made above $82,500 will be taxed at 24%. Which, frankly, isn’t much of a difference. You can also get bumped into a higher tax bracket by losing a deduction, because it increases your taxable income. Yes, being in a higher tax bracket will mean you will pay more in taxes, but don't turn down a raise because you're afraid of a new tax bracket!

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 some other factors. Altering your number of deductions changes the size of the withholdings because if you claim fewer deductions, your taxable income appears to go up, and if you claim more deductions, your taxable income appears to go down.

“Extra” income is always taxed at the highest rate. Let’s say you’re in the 22% tax bracket and you happen to make an extra thousand dollars doing some consulting work. That money is taxed at 22%, so you’d better be saving 22% of it for tax day. This is often why people end up paying more on their taxes come April – they earned some extra income.