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Do you fear earning into a higher tax bracket?

Do you fear earning into a higher tax bracket?

Stop me if you've heard this story. Your local yokel is talking about how s/he wouldn't recommend taking a promotion or raise because it will push you into a higher tax bracket. I'm here to set the record straight and provide some examples of exactly how income taxes work.

 Don't be afraid of that scary higher income bracket!

Don't be afraid of that scary higher income bracket!

The truth is that the United States uses a progressive income tax schedule and earning more will not equate to being taxed out of your raise. In general, people should always try to earn the highest amount they can, as long as the promotion or raise does not bring about work that changes their lifestyle in some other way that is undesirable (i.e. too many hours, against your moral compass, loss of other tax credits, etc). Just be careful, having the extra money might make you feel entitled to live a little.

Here's how the tax brackets looked for the 2016 tax year:

Tax rate Single filers Married filing jointly or qualifying widow(er) Married filing separately Head of household
10% Up to $9,275 Up to $18,550 Up to $9,275 Up to $13,250
15% $9,276 - $37,650 $18,551 - $75,300 $9,276 - $37,650 $13,251 - $50,400
25% $37,651 - $91,150 $75,301 - $151,900 $37,651 - $75,950 $50,401 - $130,150
28% $91,151 - $190,150 $151,901 - $231,450 $75,951 - $115,725 $130,151 - $210,800
33% $190,151 - $413,350 $231,451 - $413,350 $115,726 - $206,675 $210,801 - $413,350
35% $413,351 - $415,050 $413,351 - $466,950 $206,676 - $233,475 $413,351 - $441,000
39.6% $415,051 or more $466,951 or more $233,476 or more $441,001 or more
Tax bracket data recorded from TaxAct.com

What is not obvious from this chart is how the "progressive" income taxes would actually be billed differently when moving from one tax bracket to another. Let's go through an example of how you might increase your earnings.

Let's say you earned $37,650 of taxable income after deductions last year, the highest amount you can earn and remain in the 15% tax bracket.

You might assume that you would pay 15% on the total amount, which gives us a quick calculation. Using that same assumption, if you made just $1 more then you would jump up to a skin melting 25%.

Here's what that math would look like:

$37,650 x 0.15 = $5647.50
vs
$37,651 x 0.25 = $9412.75

If that were the way that taxes worked, then it would be horrible to jump up a tax bracket. In this example, making just $1 more would have cost $3765.25 in extra taxation. 

Fortunately, that is DEAD WRONG!

The progressive tax means all of your income is taxed in corresponding brackets. That way only your highest dollars are taxed in your highest tax bracket.  So the actual math for $37,650 works out like this:

The first $9275 is taxed at 10%.

$9275 x 0.10 = $927.50

The remaining income is in the 15% bracket. Of your total $37,650 the first $9275 has already been taxed. That leaves the remaining $28,375 taxed at 15%.

$28,375 x 0.15 = $4256.25

By adding up the tax in your two brackets, you get:

$927.50 + $4256.25 = $5183.75.
A cool $463.75 in tax savings
compared to a straight 15%.

If you would have made $1 more, only that last dollar would be taxed in the in the 25% bracket.

$1 x 0.25 = $0.25

This means you would pay a total of 25 cents more in income taxes, even though you jumped from the 15% into the 25% tax bracket. In this example, going from the top of a bracket to the bottom of a higher bracket by only $1 still earns you 75 cents - NOT the ghastly ~$4000 tax bill.

So yes, take a raise when you can get it because it generally means more money for you to save up. Let's get to earning more and saving more!

 

Time For Change

Time For Change

Who are we?

Who are we?