You've finally received a hard-earned raise. Unfortunately, that raise has bumped you into the next tax bracket. Does that mean you should tell your employer you don't want the raise after all? If all of your income is going to be taxed at a higher rate, with your new raise, you're actually going to take home a smaller paycheck. Right?
Fortunately, this statement isn't true, but it's a common misconception about how our progressive federal income tax system works. While people are taxed at higher rates when they earn higher levels of employment income, only a portion of their income, not all of their income, is taxed at the higher rate. Let's take a look at how the system works.
How to Calculate How Much Tax You Owe
As you've already noticed, the more money you earn, the more tax you pay. Not only that, but as you earn more money, you pay a progressively higher tax rate. The two tax tables below show the tax rates the IRS requires you to pay on your 2011 income if you're single or married filing jointly.
Source: 2011 Tax Rate Schedules, http://www.irs.gov/pub/irs-pdf/i1040tt.pdf
Your marginal tax rate is the rate of tax that applies to each additional dollar of income that a taxpayer earns. If you are single and you earned $34,500 a year before your raise, you were in the 15% marginal tax bracket. Your tax liability was $850 plus 15% of the amount over $8,500. The amount you earned over $8,500 was $26,000, so you owe $3,900 in tax on $26,000 and $850 in tax on $8,500 for a total of $4,750 in tax. While your marginal tax rate was 15%, your effective tax rate, or the average rate of tax you paid on your total income, was lower. To get your effective tax rate, divide your total tax by your total income. In this case, $4,750/$34,500 gives you an effective tax rate of 13.8%. (For more, check out How Your Tax Rate Is Determined.)
Now, let's look at what happens to your tax rate and the total tax you owe after your raise. Let's say you received a whopping $10,000 raise and your annual income is now $44,500. How much tax will you owe?
You already know that you owe $4,750 on the first $34,500 you earned. But now that your total income is between $34,500 and $83,600, you must pay a higher rate of tax. Your $10,000 raise bumps you into the 25% tax bracket. However, you will not pay 25% on all $44,500 of your income, just like you didn't pay 15% on all $34,500 of your income before you got a raise. The 25% rate only applies to your $10,000 raise. You'll owe an additional $2,500 a year in tax, for a total of $7,250 ($4,750 + $2,500).
What overall rate of tax are you paying on your $44,500 salary? Divide your salary, $44,500, by your total tax, $7,250, and you'll see that your effective tax rate is 16.3%, not 25%. With your raise, you're taking home an extra $7,500 a year. You may not be happy about the high percentage of your raise the government has claimed, but you are going to take home significantly more pay than you did before your raise.
Deductions and Credits
The above example is simplified; it doesn't account for the deductions and credits that reduce your taxable income. Every taxpayer can choose whether to take a standard deduction or to itemize deductions. If you're single and don't own a home, you probably don't have many deductions to itemize, so you'll take the standard deduction. The standard deduction reduces the amount of your taxable income. Instead of paying tax on all $44,500 that you earn, you'll pay tax on that amount minus the standard deduction. In 2011, the standard deduction for single filers is $5,800, reducing your taxable income to $38,700.
Whether you itemize or take the standard deduction, you're also entitled to a personal exemption, which reduces your taxable income even further. For your 2011 return, the standard exemption is $3,700. Now your taxable income is $35,000. Your marginal tax rate is still 25%, but only $500 of your income will be taxed at 25%.
The Bottom Line
The progressive tax system means that you pay different amounts of tax on different portions of your income. As you earn more money from your job, you'll pay higher rates of tax on your additional income. However, you won't pay a higher rate of tax on all of your income. So when you're up for your next raise, don't fear the tax man - negotiate your way to the highest raise possible. (For related reading, see Personal Income Tax Guide.)