A Fundamental Misunderstanding of Tax Brackets, Demystified
I was gaining steam in my career and nearing the top of 25% tax bracket (at the time), and thought to myself “it’d be great to get a raise, but then I’d be in the next bracket so I would need to earn even more to offset that!” The savvy reader will immediately smack their head at my misunderstanding of tax brackets, but the fact is no one ever taught me how they worked.
In this post, part of our series on ‘the basics,’ we’ll learn about how tax brackets work in the US and why earning more than you used to is pretty much always a good thing for you.
This has been on my mind as I’ve seen comments lately around not wanting a raise, not getting a bonus, not getting married, and things like that. All misunderstanding how tax brackets really work.
You’ve probably seen a table like this at some point and sized up where you fit:
| Income (Single) | Income (Married) | Tax Rate |
| $0-$9,949 | $0-$19,899 | 10% |
| $9,950-$40,524 | $19,900-$81,049 | 12% |
| $40,525-$86,374 | $81,050-$172,749 | 22% |
| $86,375-$164,924 | $172,750-$329,849 | 24% |
| $164,925-$208,434 | $329,850-$418,849 | 32% |
| $209,435++ | $418,850++ | 35% |
The common misunderstanding of tax brackets goes like this:
“Hmmm, I earn $86,000 right now so I pay 22%. That’s $18,920 in taxes. If I get a $500 raise it’s going to bump me up into the 24% bracket, which is $20,760 in taxes. So that $500 raise will cost me $1,840“
As you may have guessed by the fact I’m writing this, that is incorrect! Because the book definition of marginal tax rates can be a little confusing, let’s show an example.
Marginal Tax Rates, by Example
So in the scenario above, its not that the single $86,000 earner is paying 24% on their $86,000 of income. What’s actually happening is they’re paying the tax rate shown on each row of the table on the amount of income shown in that row.
So if you’re a single person making $86,000, you would pay:
| 10% on the first $9,949 | $994 |
| + 12% on the amount between $9,950 -> $40,524 | $3668 |
| + 22% on the amount between $40,525 -> $86,000 | $10,004 |
| for a total of: | $14,666 |
Meaning our $86,000 earner in the 22% tax bracket pays an effective tax rate of around 17.06%.
Going back to our scenario of that $86,000 earner getting a $500 raise:
Not only is she currently paying $14,666 rather than the $18,920 she calculated just by looking at the table, a $500 raise doesn’t have the effect she thinks. Let’s run the same scenario again to explain:
| 10% on the first $9,949 | $994 |
| + 12% on the amount between $9,950 -> $40,524 | $3668 |
| + 22% on the amount between $40,525 -> $86,374 | $10,086 |
| + 24% on the amount between $86,375 and $86,500 | $31 |
| for a total of: | $14,779 |
So that didn’t bump her tax bill by $1,840 as this common misunderstanding of tax brackets made her think. The $500 raise that put her into the next tax bracket only increased her taxes by $113 (that is…slightly less than 24% of $500).
So while she’s got her great new raise and is now in the 24% tax bracket, she’s actually paying an effective tax rate of around 17.09%. Or a 0.03% increase.
The Takeaway
Bumping up to the next bracket doesn’t come with the penalty a lot of people think. Taxes are a necessary part of our functioning society; while you may want to pay as little as possible, keep in mind that paying more taxes because you earned more money is a good thing for you!
How and where did you first learn that this is how tax brackets work?