I used to think that I could potentially take home less money if I was at the bottom of a higher income tax bracket. This video gives an example of two different people’s incomes to illustrate why that is not the case.
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Have you ever wondered how exactly income tax brackets work? I used to think that if I was at the top of one bracket and got a raise that pushed me just barely into the next bracket, I could potentially bring home less money. I know I’m not the only one who has had this misconception, so here’s an explanation.
This table represents the 2010 tax brackets. Notice that your tax rate is affected by two main factors: how much you earn and how you file your taxes, such as single or married filing jointly.
For example, if you are married filing jointly and earn $137,300, you are probably a very hard worker or doing something illegal. You are also in the 25% tax bracket.
Does that mean that you pay 25% of your $137,300 in taxes, which is $34,325? No.
Let’s illustrate why, by looking at how two people’s incomes compare: Harold earns the maximum for the 25% bracket and Becky earns the minimum for the 28% bracket. That means Harold earns $137,300 and Becky earns one dollar more or $137,301.
Let’s first look at the taxes Harold will have to pay.
The first tax bracket is 10%. That means that on everything he earns up to $16,750, he would pay 10% in taxes. So for that portion of his income he would pay 10% of $16,750, which is $1,675.
Now let’s move on to the 15% bracket. Harold will pay a tax of 15% on everything he earns after the first $16,750 up to $68,000. $68,000 minus $16,750 is $51,250. So he will pay 15% of that $51,250 in taxes, which is $7,687.50.
Continuing on with the 25% bracket, we follow the same pattern, meaning Harold pays 25% on everything he earns after $68,000 up to $137,300. So he pays 25% of $69,300 which is $17,325.
Now we need to add all of the amounts from each bracket to determine Harold’s total tax liability or what he is responsible to pay—assuming he doesn’t want to go to jail. When we add all of these together, we get $26,687.50.
Notice that $26,687.50 represents 19.4% of Harold’s $137,300 income even though he is in the 25% bracket. It’s not as bad as a straight 25%, but it’s probably about $26,000 more than he would like to pay.
Now if Becky earns just one dollar more, she is in the 28% bracket. She would pay the same amount in taxes as Harold for the first $137,300—assuming she is not a tax evader—then she would also pay 28% in taxes on the $1 she earns that falls in that 28% bracket. This means she would owe an additional $0.28 in taxes, which makes her total tax liability $26,687.78.
You can see that Becky still brings home more money than Harold, even though she just barely falls into the next higher tax bracket. So while being in a higher bracket does mean a higher percentage of your income goes toward taxes, it does not mean that you will bring home less money.
Now that you understand how tax brackets work, you don’t have to be afraid of getting a raise. And that’s a Your Two Bits explanation of tax brackets.