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 2016, single taxpayers are subject to the following federal income tax schedule:
10% $0 to $9,275
15% $9,276 to $37,650
25% $37,651 to $91,150
28% $91,151 to $190,150
33% $190,151 to $413,350
35% $413,351 to 415,050
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 $4,050 in 2016 for a single taxpayer. When you earned $36,000, your taxable income was $31,950.
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 $9,275 you earned ($927.50). On the remaining $22,675 of income ($32,050 – $9,075), you were paying a 15% tax ($3.401.25). Your total tax was $4,328.75, not $5,400. While your marginal tax rate was 15%, your effective tax rate was lower, at 12% ($4,328.75/$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 $4,050 personal exemption, your taxable income is $39,950. You’ll only pay the 25% rate on the income above $37,651, which is $2,299 in this example. Your tax bill will be calculated as follows:
10% of $9,275 = $927.50
15% of $28,376 = $4,256.4
25% of $2,299 = $574.75
Your total tax will be $5,758.65, which gives you an effective tax rate of 13%, 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.
The Advisor Insight
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 the 3.8% investment tax (i.e. Medicare surtax) 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.
Clear View Wealth Advisosr, LLC