Can moving to a higher tax bracket cause me to have a lower net income?
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:
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
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.
While the primary analysis previously written here is correct (higher income won't cause your overall net income to decrease, at least not from the direct taxes you owe), there's a missing piece to the analysis. It's altogether possible that your current level of income enables you to be eligible for certain subsidies or other government benefits—health care subsidies through ACA, for example, or any number of phaseouts of deductions that occur at certain levels of income (tax deductibility of student loan interest, certain retirement plan contributions, etc).
In other words, it's not just the tax brackets that respond to changes in your AGI (adjusted gross income). It's any number of deductions, exemptions, and other subsidies as well. To the degree that certain benefits that you currently enjoy rely upon you remaining in a lower tax bracket, your overall financial position might in fact deteriorate with a higher income, even if the shift into the tax bracket alone isn't the reason why.
When your income increases, you may jump tax brackets, and therefore your taxes would increase. It is a common misconception that when that happens, your net income may lower.
The highest current federal tax bracket is 39.6%. When you are in that bracket, any additional $100 that you may earn would generate $39.60 in federal taxes. Hence, you would get to keep $60.10. Although it is a substantial tax bite, your income would still continue to increase. Of course, adding state and local taxes may alter this picture somewhat.
Yes, it is possible. Depending on your income, before and after, you may be on the cusp between marginal tax brackets. And by crossing the line to the higher bracket, you may find that you're in AMT (Alternative Minimum Tax) territory where you may also lose certain itemized deductions. Depending on the composition of income (earned versus investment) and the amounts, you may also find your income subject to the 3.8% Investment Tax (i.e. Medicare Surtax) as well.
The more common situation is that your marginal rate will increase when your adjusted gross income increases. You'll probably have more cash inflow, but your effective tax rate will be higher (meaning a higher proportion goes to taxes).
But if your income is high enough, you may find your cash flow increases just because you no longer are required to pay into Social Security (earnings upon which this is taxed are capped).
To really determine the impact on your cash flow and taxes, you should consult with a qualified tax planner.
With all due respect, the answer to this question that has been provided by Investopedia is overly simplistic. While it is generally true that a bump into the next federal marginal tax bracket does not result in a lowering of net income, there are exceptions. These exceptions generally have to do with the phase out of exemptions and itemized deductions that may occur as income rises. For more on this topic, see the following article links –
- Disappearing Deductions Cost Taxpayers (CBS Money Watch)
- How do phase outs of tax benefits affect taxpayers? (Tax Policy Center)
- PEP And Pease Limitation Are Really 1% Income Surtaxes (Kitces.com)