Many people believe that when their income increases enough to move them into a higher tax bracket, their overall take-home pay, or net pay, will decrease. This assumption is incorrect.
The U.S. has a progressive tax system, also known as a marginal tax rate system. That means, 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.
In other words, 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 401(k) plan options.
- In the U.S., the tax system is based on marginal taxation, whereby income is only subject to the tax rate earned within that bracket.
- So, if you earn $45,000 in the year 2020 and file single, the first $9,875 is subject to 10% tax, the next $30,250 will be taxed at 12%, and the remaining $4,875 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 years 2020 and 2021, single taxpayers are subject to the federal income tax schedules below.
|Rate by Income/Taxpayers Filing as Single|
|Tax Rate||Income Range 2020||Income Range 2021|
|10%||$0 to $9,875||$0 to $9,950|
|12%||$9,876 to $40,125||$9,951 to $40,525|
|22%||$40,126 to $85,525||$40,526 to $86,375|
|24%||$85,526 to $163,300||$86,376 to $164,925|
|32%||$163,301 to $207,350||$164,926 to $209,425|
|35%||$207,350 to $518,400||$209,426 to $523,600|
|37%||$518,401 or more||$523,601 or more|
Here's an example of incorrect thinking of how the tax bracket system works. Suppose you get a raise and your annual salary goes from $39,000 to $42,000 for 2021. Many people, again incorrectly, think that they pay 12% on their $39,000 salary, or $4,680, leaving them with $34,320 in take-home pay. Thus, after their salary increase and tax bracket change, they will owe a tax of 22% on their $42,000 salary, or $9,240, leaving them with $32,760 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—where the first dollars you earn are taxed at the lowest rate, and the last dollars you earn are taxed at the highest rate.
Here is an example of the correct way to assess the tax implications of the aforementioned salary increase.
- You will owe 10% on the first $9,950 you earn in 2021—or $995.
- You will owe 12% on the $9,951 to $40,525 earned—or $3,669.
- You will owe 22% on the $40,526 to $42,000 earned—or $324.50.
Thus, your total tax due is $4,988.50. While your marginal tax rate is 22%, your effective tax rate is much lower, at 11.9% ($4,988.50 / $42,000).
Thus, when your income increases from $39,000 to $42,000, you’re still very close to the effective tax rate you would have paid on $39,000 in 2020—11.5%, or [($9,875 * 10%) + ($29,125 * 12%)] / $39,000.
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.
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.
IRS. "IRS provides tax inflation adjustments for tax year 2020." Accessed Oct. 27, 2020.
IRS. "IRS provides tax inflation adjustments for tax year 2021." Accessed Oct. 27, 2020.