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 progressive, or marginal tax rate system, when an increase in income pushes you into a higher tax bracket, you only pay the higher tax rate on that portion of your income that exceeds the income threshold for the next-highest tax bracket. In other words, don't worry! Getting paid more might push you into a higher tax bracket but will not lead to lower take-home pay. Though, you may want to consider specific 401k plan options.

Key Takeaways

  • In the U.S. there is a system of marginal taxation, whereby tax brackets describe the income tax rate subject to only that income earned within that bracket.
  • So, if you earn $40,000 in the year 2019, the first $9,700 is subject no tax, the next $29,774‬ will be taxed at 12% and the remaining $525 at 22%.
  • Therefore, getting paid more and moving into a higher tax bracket WILL NOT cause you to have a lower net income!

Example of Marginal Taxation

This concept is easier to understand with an example. For the tax year 2019, single taxpayers are subject to the following federal income tax schedule:

Rate by Income

  • 10% $0 to $9,700
  • 12% $9,701 to $39,475
  • 22% $39,476 to $84,200
  • 24% $84,201 to $160,725
  • 32% $160,726 to $204,100
  • 35% $204,101 to $510,300
  • 37% $510,301 or more

Suppose you get a raise and your annual salary increases from $39,000 to $41,000. Many people incorrectly think that whereas they previously paid a tax of 12% of $39,000, or $4,680, leaving them with $34,320 in take-home pay, after their salary increase and tax bracket change, they will pay a tax of 22% on $41,000, or $9,020, leaving them with $31,980 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.

The way the marginal tax system works is that 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 12% tax on the first $39,475 you earned ($4,739). On the remaining $1,525 of income ($41,000 - $39,475), you were paying a 22% tax ($335). Your total tax was $5,074, not $9,020. While your marginal tax rate was 22%, your effective tax rate was lower, at 12.4% ($5,072/$41,000).

Thus, when your income increases from $39,000 to $41,000, you’re still very close to the 12% tax bracket where you were before your raise.

For simplicity’s sake, we’ve excluded tax deductions from this example, but in reality, the standard deduction or your itemized deductions could 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.

Advisor Insight

Steve Stanganelli, CFP®, CRPC®, AEP®, CCFS
Clear View Wealth Advisors, LLC, Amesbury, MA

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 also.

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.