Can moving to a higher tax bracket cause me to have a lower net income?

By Amy Fontinelle AAA
A:

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. Because 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.

This concept is easier to understand with an example.

For the tax year 2014, single taxpayers are subject to the following federal income tax schedule:

Rate    Income

10%     $0 to $9,075

15%     $9,076 to $36,900

25%     $36,901 to $89,350

28%     $89,351 to $186,350

33%     $186,351 to $405,100

35%     $405,101 to 406,750

39.6%  $406,751+

Suppose you get a raise and your annual salary increases from $36,000 to $38,000. Many people incorrectly think that whereas they previously paid a tax of 15% of $36,000, or $5,400, leaving them with $30,600 in take-home pay, after their salary increase and tax bracket change, they will pay a tax of 25% on $38,000, or $9,500, leaving them with $28,500 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.

First of all, the personal exemption reduces your taxable income by $3,950 in 2014 for a single taxpayer. When you earned $36,000, your taxable income was $32,050.

Next, the way the marginal tax system works, 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 a 10% tax on the first $9,075 you earned ($907.50). On the remaining $22,975 of income ($32,050 – $9,075), you were paying a 15% tax ($3.446.25). Your total tax was $4,353.75, not $5,400. While your marginal tax rate was 15%, your effective tax rate was lower, at 12% ($4,353.75/$36,000).

Thus, when your income increases to $38,000, you’re actually still in the 15% tax bracket thanks to the personal exemption. But let’s see what happens when you really do move into the 25% tax bracket. Suppose you get a raise from $36,000 to $44,000. After the $3,950 personal exemption, your taxable income is $40,500. You’ll only pay the 25% rate on the income above $36,900, which is $3,600 in this example. Your tax bill will be calculated as follows:

10% of $9,075 = $907.50

15% of $27,825 = $4,173.75

25% of $3,600 = $900.00

Your total tax will be $5,981.25, which gives you an effective tax rate of 14%, not 25%.

For simplicity’s sake, we’ve excluded tax deductions from this example, but in reality, the standard deduction or your itemized deductions will 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.

RELATED FAQS

  1. What is the best method of calculating depreciation for tax reporting purposes?

    Learn the best method for calculating depreciation for tax reporting purposes according to generally accepted accounting ...
  2. Who is exempt from paying Social Security taxes?

    Learn about the groups of people who qualify for exemption from Social Security taxes, and explore the process of applying ...
  3. Can you write variable costs off your taxes?

    Learn if you can deduct variable or fixed costs from your business taxes and learn more about business deductions, cost of ...
  4. What are the tax incentives or disincentives to vertical integration?

    Merging companies through vertical integration can provide companies in the United States with a marginally advantageous ...
RELATED TERMS
  1. Marginal Tax Rate

    The amount of tax paid on an additional dollar of income. The ...
  2. Tax Bracket

    The rate at which an individual is taxed. Tax brackets are set ...
  3. Federal Tax Brackets

    Income tax groupings specified by the Internal Revenue Service ...
  4. Guideline Premium And Corridor Test (GPT)

    A test used to determine whether an insurance product can be ...
  5. Cash Value Accumulation Test (CVAT)

    A test method used to determine whether a financial product can ...
  6. Section 7702

    The section of the United States Internal Revenue Code that defines ...

You May Also Like

Related Articles
  1. Taxes

    New Tax Rules Target The Top Tax Bracket

  2. Taxes

    5 Surprise Costs That May Affect Your ...

  3. Insurance

    Avoid The No-Health-Insurance Penalty ...

  4. Economics

    EU Probes Tax Laws To Catch Corporate ...

  5. Professionals

    Multiple Accounts? Here's How to Calculate ...

Trading Center