There was a post I saw on Reddit this week. It was about a co-worker who turned down a $2,000 bonus because it put him into the next tax bracket. It spoke of a man who wouldn’t back down in his belief that he did the right thing. More importantly, it spoke to a gross misunderstanding as to how our tax brackets work.
It’s a common mistake and I see it all the time. You’ll often even hear it in political discourse when someone suggests a higher tax rate on the rich.
That mistake comes from a misconception of how tax brackets work. Let’s take a look at the 2019 single tax brackets below.
The United States has a progressive tax system meaning people with higher incomes pay a higher tax. However, the issue arises because people don’t understand the difference between the tax rate and the marginal tax rate.
In essence, some believe that the tax rate in the bracket you’re in applies to the entirety of your income.
In that world, someone with $38,000 in taxable income would pay a tax rate of 12%. Now, if they got a bonus and earn $40,000 in taxable income, they would pay a tax rate of 22%.
If you believe that(you’re wrong) then you can see how giving up a $2000 bonus might make sense. It’s simple(wrong) math! In this scenario, a rate of 12% on $38,000 means 4560 in taxes and and after tax income of $33,440. A rate of 22% of $40,000 means 8800 on taxes and an after tax income of $31,200! It clearly makes sense to not take the bonus and pay the lower rate.
However, luckily, that’s not how it works. It would make 0 sense to have a tax system that punishes success in any way.
The IRS utilizes a progressive tax system. The portion of your income that falls into each bracket defines how much tax you owe. That means that different parts of your income are taxed at different rates. You can’t simply look at the table above and determine your tax rate.
In simple terms, the IRS splits your income into pieces to which they apply the corresponding tax rate. The first $9,700 earned will be taxed at 10%, the next dollars earned until $39,475 will be taxed at 12% and so on.
Let’s take a look at our illustration above using the proper calculation of taxes. Again, we’re comparing our single person and his $2,000 bonus. That means $38,000 in taxable income before the bonus. After the bonus, it means $40,000 in taxable income.
The IRS splits your income into smaller pieces based on the defined tax bracket and the income within each bucket is taxed at the bracket rate(10%,12% and 22%).
You can see that the bonus does cause the taxes owed to be higher. That makes sense because it means you’re earning more. However, the extra $2,000 only pushes a small portion of the income into the next marginal tax bracket.
In this example, the $38,000 income is in the 12% marginal tax rate meaning the next dollar of income will be taxed at 12%.
The 22% rate only matters after the bonus and only for a small portion of the overall taxable income.
Next is the key word here as the higher tax rates require additional income to matter.
The actual effective tax rate which is what matters(the amount of taxes paid versus taxable income) doesn’t change much. It’s 11.49% when earning $38,000 and 11.65% when earning $40,000. The majority of the income is still taxed in the same tax brackets for both incomes and the difference is that a small portion gets pushed into the 22% bracket after the bonus.
That means that making more money will never mean you’ll be taking home less. That just doesn’t make sense.
To illustrate it another way, think of someone making $400,000 and someone making $50,000. These people will pay the SAME rate on the first $9,700 of their income. They will pay the same rate on the income in the next brackets until their incomes diverge. The person earning $400k will end up paying more taxes(even as a % of their income) as they have more income falling into higher tax brackets.
However, it’s not just his final income that defines his actual tax rate, it’s how much of that income falls into the specific brackets. The person making $400,000 will pay a rate much lower than 35% because only the income after $204,401 will be taxed at that rate.
It’s important to always keep this information in mind when thinking about taxes. It’s always better to make more money because the post-tax income will increase. You will pay a bit more in overall taxes but the actual take home will still increase.
The progressive tax rate and how tax brackets work is also important to keep in mind whenever you hear talk of high tax rate proposals. These will almost always be marginal tax rates on income above a certain level.
That high rate will only apply to income above a certain level. It will not be a rate applicable to the entirety of the income. If someone proposes a 90% rate above $10,000,000 then remember that a lot of that income(everything below $10M will be taxed below 90%).
There’s one important caveat to keep in mind here. This information may not always be clear on your paycheck.
There’s a difference between taxes owed and taxes withheld. Your employer withholds taxes based on internal tables provided by the IRS. There are situations where a bonus can cause your withholding rate to be much higher than what it should be(more information on that here).
That’s just a payroll issue and not a function of taxes owed. Your employer does their best to estimate taxes owed but as evidenced by the number of refunds, they often don’t do a great job. The actual taxes owed and the taxes as withheld in your paycheck don’t always go hand in hand. If there’s an issue with your withholding due to a bonus, you’ll get that money back as a refund when you do your taxes and calculate actual tax liability.
Also, keep in mind that this is a very high level overview of how taxes work. All the numbers here assume taxable income after deductions to keep things simple. Another important item to keep in mind is that federal taxes aren’t the only “tax” you pay. There may also be state taxes and FICA(social security and medicare) that impact your actual take home pay.
Still, the overall lesson here is that making more money is never a bad idea. There are some very rare cases where making more money could be bad like if it phases you out of poverty level credits. If you’re in that area, consult a tax professional. However, for the majority, this applies.
The key takeaway is that it’s not your overall salary that gets hit with a tax rate in said bracket, only the income in that bracket. If you get a $2,000 bonus, please take it! It won’t magically make your tax rate soar 10%. That’s now how tax brackets work. It will marginally increase your taxes as a small portion of your income gets pushed into a higher bracket. It’s that marginal part that really matters in the end.