Some people worry that if their income increases enough to push them into a higher tax bracket, their overall take-home pay, or net income, will decrease. Fortunately, that isn't how the tax system in the United States works.
- In the U.S., the tax system is based on marginal tax brackets, with different levels of income taxed at different rates.
- If you have a taxable income of $42,000 in 2021, for example, and you file as a single taxpayer, the first $9,950 is subject to 10% tax, the next $30,575 is subject to 12% tax, and the remaining $1,475 is subject to 22% tax.
- Although getting paid more might move you into a higher marginal tax bracket, it won't result in a lower net income.
How Tax Brackets Work
The U.S. has a progressive tax system, using marginal tax rates. Therefore, when an increase in income moves 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.
In other words, a raise might push some of your additional income into a higher tax bracket, but it won't cause your other income to be taxed at that rate or lower your take-home pay.
The concept of a marginal tax bracket is probably easiest to understand with an illustration. Here are the tax rates single taxpayers will pay for tax year 2021.
|Rate by Income/Taxpayers Filing as Single|
|Tax Rate||Taxable Income Ranges 2021|
|10%||$0 to $9,950|
|12%||$9,951 to $40,525|
|22%||$40,526 to $86,375|
|24%||$86,376 to $164,925|
|32%||$164,926 to $209,425|
|35%||$209,426 to $523,600|
|37%||$523,601 or more|
Suppose your taxable income is $40,000 a year and you get a $2,000 raise, making your taxable income $42,000. Previously your highest tax bracket was 12% because your income didn't exceed $40,525. Now your highest tax bracket is 22%. But only $1,475 of your income ($42,000 - $40,525) will be taxed at that rate. The rest will be taxed at 12% or less. Here, with some rounding, is how it breaks down:
- You will be taxed at a rate of 10% on the first $9,950 of taxable income—or $995.
- Then, you will be taxed at 12% on the next $30,575 of income ($40,525 - $9,950)—or $3,669.
- Finally, you will be taxed at 22% on the remaining $1,475 of your income—or $325.
So, your total tax will be $4,989. That works out to an overall tax rate of about 12%.
Now, suppose you hadn't gotten the $2,000 raise.
Using the same math as above, your tax bill (on $40,000 in income) would be $4,601 (10% x $9,950 + 12% x $30,050).
Bottom line: Your $2,000 raise has added $388 to your taxes, but you're still ahead by $1,612.
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.
Steve Stanganelli, CFP®, CRPC®, AEP®, CCFS
Clear View Wealth Advisors, LLC, Amesbury, Massachusetts
Depending on your income, before and after, you may be on the cusp between marginal tax brackets. And by crossing the line to a higher bracket, you may find that you're in alternative minimum tax territory where you may also lose certain itemized deductions. Depending on the composition of income (earned versus investment) and the amounts, your income could be subject to a 6.2% Social Security tax and a 1.45% Medicare tax rate.
A more common situation is that your marginal rate will increase when your adjusted gross income rises. You'll probably have more cash inflow, but your effective tax rate will be higher.
If your income is high enough, you may find your cash flow increases because you no longer are required to pay into Social Security. Earnings upon which this is taxed are capped.
Internal Revenue Service. "IRS Provides Tax Inflation Adjustments for Tax Year 2021." Accessed Oct. 27, 2020.