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 2016, single taxpayers are subject to the following federal income tax schedule:

Rate Income

10% $0 to $9,275

15% $9,276 to $37,650

25% $37,651 to $91,150

28% $91,151 to $190,150

33% $190,151 to $413,350

35% $413,351 to 415,050

39.6% $415,051+

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 $4,050 in 2016 for a single taxpayer. When you earned $36,000, your taxable income was $31,950.

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 $9,275 you earned ($927.50). On the remaining $22,675 of income ($32,050 – $9,075), you were paying a 15% tax ($3.401.25). Your total tax was $4,328.75, not $5,400. While your marginal tax rate was 15%, your effective tax rate was lower, at 12% ($4,328.75/$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 $4,050 personal exemption, your taxable income is $39,950. You’ll only pay the 25% rate on the income above $37,651, which is $2,299 in this example. Your tax bill will be calculated as follows:

10% of $9,275 = $927.50

15% of $28,376 = $4,256.4

25% of $2,299 = $574.75

Your total tax will be $5,758.65, which gives you an effective tax rate of 13%, 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. If I have 5 tax years before I must take an RMD, how much tax benefit will it be ...

    My effective tax bracket for 2016 is 1.28% due to being retired with only pension and SS income.  ... Read Answer >>
  2. What is the difference between income tax and capital gains tax?

  3. How can I find out which income tax bracket I am in?

    Find out how to determine your federal income tax bracket and calculate how much you will owe in federal taxes with online ... Read Answer >>
  4. How do I calculate my effective tax rate using Excel?

    Find out how to calculate your effective tax rate using Microsoft Excel, what income tax rates to apply to your earned income ... Read Answer >>
  5. What is the highest marginal tax rate in the United States?

    Find the highest marginal tax rate in the United States, calculate your taxable income, and maximize your returns by moving ... Read Answer >>
  6. What's the difference between a tax rate and a tax bracket?

    These two terms are often incorrectly used interchangeably. Find out the difference between your tax rate and your tax bracket. ... Read Answer >>
Related Articles
  1. Personal Finance

    How Getting A Raise Affects Your Taxes

    Many people think they may actually make less overall because they are paying more taxes.
  2. Financial Advisor

    Federal Tax Brackets

    Why do we have income tax brackets? What do they do for us? Read this to understand the basics and where to find your own bracket.
  3. Investing

    Personal Income Tax Guide: Basic Concepts

    By Ken ClarkOne of the most important but misunderstood concepts in tax planning is the mechanics of the United States' progressive tax system. When asked how this system functions, most people ...
  4. Personal Finance

    Comparing Long-Term vs. Short-Term Capital Gain Tax Rates

    Learn about the difference between short- and long-term capital gains and how the duration of your investment can impact your tax liability.
  5. Personal Finance

    How Are Capital Gains And Dividends Taxed Differently?

    Individuals in the 25% or higher tax bracket pay a 20% tax on long-term capital gains.
  6. Personal Finance

    What's a Marginal Tax Rate?

    The marginal tax rate is based on a progressive tax system, where tax rates for an individual will increase as income rises. This method of taxation aims to fairly tax individuals based upon ...
  7. Managing Wealth

    5 Ways to Reduce Your Taxes After a Windfall Gain

    Windfall income is a welcome padding to any bank account, but plan for the government's share before you start spending.
  8. Personal Finance

    Why America's Taxes Are Too Low

    The solution to America's economic woes may not be in lowering taxes further, but may, in fact, lie in increasing them.
  9. Personal Finance

    3 Common Tax Questions Answered

    We clarify some rules that often puzzle taxpayers.
  10. Personal Finance

    Next Season, File Taxes On Your Own

    Master these fundamentals and you'll be doing your own taxes with minimal stress.
RELATED TERMS
  1. Federal Tax Brackets

    Income tax groupings specified by the Internal Revenue Service ...
  2. Effective Tax Rate

    The average rate at which an individual or corporation is taxed. ...
  3. Flat Tax

    A system that applies the same tax rate to every taxpayer regardless ...
  4. Tax Base

    The assessed value of a set of assets, investments or income ...
  5. Vertical Equity

    A method of collecting income tax in which the taxes paid increase ...
  6. Tax Rate

    The percentage at which an individual or corporation is taxed. ...
Trading Center