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.

  1. Can I borrow from my annuity to put a down payment on a house?

    You can borrow from your annuity to put a down payment on a house, but be prepared to pay an assortment of fees and penalties. ... Read Full Answer >>
  2. Why is the Cayman Islands considered a tax haven?

    The Cayman Islands is one of the most well-known tax havens in the world. Unlike most countries, the Cayman Islands does ... Read Full Answer >>
  3. Why is Panama considered a tax haven?

    The Republic of Panama is considered one of the most well-established pure tax havens in the Caribbean due to extensive legislation ... Read Full Answer >>
  4. How do I get out of my annuity and transfer to a new one?

    If you decide your current annuity is not for you, there is nothing stopping you from transferring your investment to a new ... Read Full Answer >>
  5. Are Cafeteria plans exempt from Social Security?

    Typically, qualified benefits offered through cafeteria plans are exempt from Social Security taxes. However, certain types ... Read Full Answer >>
  6. Why is Andorra considered a tax haven?

    Andorra is one of many locations around the globe considered a tax haven because of its relatively lenient tax laws. However, ... Read Full Answer >>
Related Articles
  1. Taxes

    New Tax Rules Target The Top Tax Bracket

    The American Taxpayer Relief Act brings about new tax rules for the wealthy that people such as Warren Buffett have been calling for over the last few years.
  2. Taxes

    5 Surprise Costs That May Affect Your Tax Bracket

    Surprise! You may owe more than you think.
  3. Economics

    Explaining Corporate Tax

    A corporate tax is a tax levied on the profits a corporation generates.
  4. Taxes

    The 5 Countries Without Income Taxes

    Discover information on some of the best countries to consider relocating to that offer the financial benefit of charging no income tax.
  5. Professionals

    Tax Efficient Strategies for Mutual Funds

    Before you sell mutual fund shares, consider these tax strategies first.
  6. Retirement

    How Much Can You Contribute to Your 401(k)?

    Given the fairly high compensation limits on these retirement plans, most workers can pitch in more than they currently do.
  7. Taxes

    Tax Haven Vs. Tax Shelters: Is There a Difference?

    Learn about the difference between tax havens and tax shelters, and how both are used to reduce tax liability or avoid paying taxes altogether.
  8. Professionals

    Dodging the Dangers of Self-Directed IRAs

    Self-directed IRAs are an attractive option for investors looking to build nest eggs. But they should exercise caution in avoiding prohibited transactions.
  9. Professionals

    Top Strategies for Tax-Free Roth IRA Conversions

    Finding a way to convert a traditional IRA to a Roth IRA is a tricky process. Here's when it makes sense to do so.
  10. Professionals

    Using Tax-Loss Harvesting to Keep Your Gains

    Harvesting tax losses is a key skill that investors can use to keep more of their money in their pockets the next time they file taxes.
  1. Tax Bracket

    The rate at which an individual is taxed. Tax brackets are set ...
  2. Marginal Tax Rate

    The amount of tax paid on an additional dollar of income. The ...
  3. Federal Tax Brackets

    Income tax groupings specified by the Internal Revenue Service ...
  4. Section 1231 Property

    A tax term relating to depreciable business property that has ...
  5. Exchange-Traded Mutual Funds (ETMF)

    Investopedia explains the definition of exchange-traded mutual ...
  6. Guideline Premium And Corridor Test (GPT)

    A test used to determine whether an insurance product can be ...

You May Also Like

Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!