Today we take a crack at simplifying a concept that I’ve found is misunderstood by a pretty large portion of the population. As always, this has nothing to do with people being “smart” or not, but is more about the sort of common knowledge that gets passed around in our society and the lack of any real formal education taking place in matters related to personal finance. So, I don’t want anyone to ever feel like this stuff is too hard or to feel bad for not already knowing it. The goal here is to build and expand your base of knowledge so you can then apply it to your own life and then just win all over the place.
What are we talking about here?
There are many different forms of taxation that exist in the world and some of them are called taxes and some of them aren’t. For example, you can get taxed for owning property (like a home or car), for buying things (food/drink/retail items), or for living in a certain location (state income taxes). There are also items like social security, medicare, and unemployment insurance that get taken out of your income like taxes, but are arguably different.
So there’s a lot of area there to get deep in the weeds and try to optimize things, but as this is a “101” style article, we’re going to be focusing on just one main area: the taxes that you pay to the federal government (United States here, though many countries operate in similar ways) on the money that you’re earning each year as income. I’m also not going to get into things like small businesses and self employment; for this discussion let’s keep it simple and assume W-2 income from regular, full time jobs at say, Initech…
Why the confusion?
Well plenty of reasons, but the one I see often and wanted to address is a misunderstanding about the concept of “Marginal Tax Brackets”. Take a look at the following tables with the 2017 rates for married couples filing jointly (a quick googling will find you the brackets for single filers or other classifications):
|10%||$0 to $18,650|
|15%||$18,650 to $75,900|
|25%||$75,900 to $153,100|
|28%||$153,100 to $233,350|
|33%||$233,350 to $416,700|
|35%||$416,700 to $470,700|
This is how many people (mis)understand tax brackets. Let’s take an example couple where each spouse makes 50k per year, so they make 100k combined and they’re in the 25% tax bracket. While this is fine so far, it leads to the following misconception: that they now owe 25% on that 100k, or $25,000 in taxes. Not only is this incorrect, but it leads to the really troublesome assumption that earning more income could be bad if it pushes you over into the next tax bracket. If this couple had been making $75k total (and therefore in the 15% bracket) they’d be justified in trying to avoid a raise to $76k if it meant they’d be paying 10% more in taxes and actually earn less overall. Fortunately, that’s not how it works.
Instead, let’s take a look at another way of explaining the brackets- by what is owed, rather than just the “rate”.
|$0 to $18,650||10% of taxable income|
|$18,650 to $75,900||$1,865 plus 15% of the excess over $18,650|
|$75,900 to $153,100||$10,452.50 plus 25% of the excess over $75,900|
|$153,100 to $233,350||$29,752.50 plus 28% of the excess over $153,100|
|$233,350 to $416,700||$52,222.50 plus 33% of the excess over $233,350|
|$416,700 to $470,700||$112,728 plus 35% of the excess over $416,700|
|$470,700+||$131,628 plus 39.6% of the excess over $470,700|
This better version helps illustrate what is meant by the word “marginal”. Your marginal bracket isn’t what you pay on all of your income, but rather the most that you pay on a portion of your income. It’s the rate that you pay for each additional dollar earned (each marginal increase). For that second bracket, you’re paying the 10% owed on the first $18,650 (which = $1,865) and then 15% just on the dollars on top of those first $18,650, rather than on all of your income. Each bracket includes the taxes on the money from all of the brackets that came before it and then taxes the excess at the marginal rate.
Let’s take that $100k earning couple as an example again. They’re going to owe (and again this is a simplified example):
- 10% on the first $18,650 they earn which = $1,865
- 15% on the next set of earnings between the first $18,650 and $75,900 which = $8,587.50
- 25% on what’s left above $75,900 meaning $24,100 which = $6,025
This comes out to a total tax of $16,477.50 which is an average tax rate of 16.5%, much lower than their stated rate of 25%. This will generally be further reduced by a number of deductions, credits, exemptions, and all sorts of other made up sounding accounting terms. So, they’ll actually end up paying much less than that, but that’s outside the scope of this discussion.
So, you can see just how significant a difference there can be between the marginal bracket that you’re in and the actual amount of taxes you owe. Additionally, thinking back to that fear about getting a raise and actually taking home less, we can see it’s unfounded. If the couple (maybe earlier in their careers) had gone from $75k to $76k in income, as we said- they’re only paying 25% on the last $100 that they earned (the money above $75,900) rather than on their entire earnings for the year. This means their total tax would go from $10,317.50 to $10,477.50, an increase of just $160. (Stay tuned, we’ll talk about how they could avoid even that increase in future discussions)
The main takeaway here: Earning the extra $1000 pockets them an extra $840, even though they entered a new tax bracket. You don’t need to worry about losing money because you earned more and changed tax brackets, the new rate only applies to those marginal dollars- the ones you earn above and beyond the lower brackets.
I know that taxes are often a highly charged, political topic, but I didn’t want any of that mess as a part of this discussion. This isn’t about making judgments on how things should be, but trying to understand how they are and how it affects you. I want us to come away from this with a better understanding of the basics of our tax code so that we’re making decisions in our lives from a basis of knowledge, rather than assumptions. I hope the numbers above showed pretty clearly that moving into a higher tax bracket is usually a good thing because you’re going to be pocketing more money at the end of the day. In upcoming articles, we’ll discuss some of the more complicated ways that taxes play a role in our lives and how to use them to your advantage!
- If you’re an aspiring CPA or maybe you have insomnia and need something to knock you out this evening, the IRS has publications and FAQs on every tax topic imaginable.
- In the next installment in this series, Tax Brackets 102, we’ll be looking at Capital Gains and Dividend Income and how they tie in with these brackets we’ve discussed. It turns out that in America, you can keep more of your income if it’s coming from investments than if it’s coming from your employer. We’ll discuss how that all works and ways to use it to your advantage.
- Don’t be afraid to earn more– I know this sounds like the sort of things Daddy Warbucks would say to someone living on the street, but that’s not how I intend it. There are steps that anyone can take to increase their income, whether by switching jobs, getting a raise, or taking on a side hustle. My main point here is that, within the realm of taxes, earning more is pretty much always going to be a positive thing; even though you’ll be paying more in taxes, your net take home will still be higher because of the way these brackets work. When it comes to increasing your salary, I really like some of the advice from Ramit Sethi on the topic of how to negotiate salary for a new job and how to get a raise at your current job. ESI Money also has some great thoughts on getting a raise.
- Start to look at ways to reduce your taxes– We’ll talk more about this in future discussions, but a great place to start is by contributing as much as you’re able to into your 401k/403b or other pre-tax retirement vehicles. They reduce your “taxable income” with the IRS and you can save thousands!