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Does being in a higher tax bracket mean I take home less money?

Does being in a higher tax bracket mean I take home less money?

Many people think that when their income increases by just enough to push them into a higher tax bracket, their overall take-home pay, or net pay, will decrease. This assumption is incorrect. The United States has a marginal tax rate system, when an increase in income pushes you into a higher tax bracket, you only pay the higher tax rate on the portion of your income that exceeds the income threshold for the next-highest tax bracket.

For example, for the tax year 2019, single taxpayers are subject to the following federal income tax schedule:

Rate Income

10% $0 to $9,700

12% $9,701 to $39,475

22% $39,476 to $84,200

24% $84,201 to $160,725

32% $160,726 to $204,100

35% $204,101 to $510,300

37% $510,301 or more

Suppose you get a raise and your annual salary increases from $39,000 to $41,000. Many people incorrectly think that whereas they previously paid a tax of 12% of $39,000, or $4,680, leaving them with $34,320 in take-home pay, after their salary increase and tax bracket change, they will pay a tax of 22% on $41,000, or $9,020, leaving them with $31,980 in take-home pay. If this were true, we would need to perform some careful calculations before deciding whether to accept a raise from an employer. Fortunately, the tax system doesn’t work this way.

The way the marginal tax system works is that you pay different tax rates on different portions of your income. The first dollars you earn are taxed at the lowest rate, and the last dollars you earn are taxed at the highest rate. In this case, you paid 12% tax on the first $39,475 you earned ($4,739). On the remaining $1,525 of income ($41,000 – $39,475), you were paying a 22% tax ($335). Your total tax was $5,074, not $9,020. While your marginal tax rate was 22%, your effective tax rate was lower, at 12.4% ($5,072/$41,000).

Thus, when your income increases from $39,000 to $41,000, you’re still very close to the 12% tax bracket where you were before your raise. For simplicity’s sake, we’ve excluded tax deductions from this example, but in reality, the standard deduction or your itemized deductions could give you a lower tax bill than what we’ve shown here.

So the next time you receive a raise, don’t let concerns about tax brackets dampen your enthusiasm. You really will take home more money in each paycheck.

If you have any questions on what your effective tax rate is of how we can help you properly plan your taxes, click here to speak to one of our tax professionals.

 

Source: https://www.investopedia.com

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