Many people fear that winning a raise will catapult them into a higher tax bracket, and they'll wind up worse off than they were before. But this is a somewhat misguided notion about how the progressive federal income tax system used in the U.S. works. While those who receive salary increases are indeed taxed at higher rates, only the added income is vulnerable to the increased rates.
This article explains how the taxation model truly works.
How to Calculate How Much Tax You Owe
It's a fact: The more you earn, the more taxes you pay. But the progressively higher tax rate takes some of the sting from pulling in more cash. The tables below show the tax rates the IRS required you to pay for tax year 2020 if you were single:
Your marginal tax rate is the rate of tax that applies to each additional dollar of income earned. If you're single and earned $39,475 a year before a raise, you were in the 12% marginal tax bracket. Your tax liability for 2020 was $987.50 plus 12% of the amount over $9,875. So, you owe $987.50 plus 12% of $29,600, which is $3,552. Your total tax for 2020 is $4,539.50.
While your marginal tax rate was 12%, your effective tax rate, or the average rate of tax you paid on your total income, was lower. To calculate your effective tax rate, divide your total tax by your total income. In this case, $4,539.50/39,475 gives you an effective tax rate of 11.5%.
Now, let's see what happens to your tax liability if you get a $10,000 raise that elevates your annual income for 2020 to $49,475. You already know that you owe $4,539.50 on the first $40,125 you earned. But now that your total income falls between $40,125 and $85,525, your $10,000 raise bumps you into the 22% tax bracket. Fortunately, that 22% rate only applies to your $10,000 additional income. For that, you would owe an extra $2,200 a year in tax, for a total tax bill of $6,743 ($4,539.50 + $2,200).
To determine your overall tax rate for your $49,475 salary, simply divide your total tax ($6,743) by your total income ($49,475) to reveal an effective tax rate of 13.6%, not 22%.
Changes for Tax Year 2021
The tax tables are updated annually by the IRS. For tax year 2021, the income ranges here will be adjusted as follows: The 12% tax bracket is levied on income from $9,950 to $40,525. The 22% tax bracket is levied on income from $40,525 to $86,375.
Deductions and Credits
The aforementioned example doesn't account for the deductions and credits that may potentially reduce your taxable income. Every taxpayer can choose whether to take a standard deduction or itemize deductions.
Single individuals who don't own their own homes probably don't have many deductions to itemize, so a standard deduction makes more sense. In fact, most Americans now use the standard deduction since it nearly doubled in size in 2018.
Instead of paying tax on all $49,475 that you earn, you'll pay tax on that amount minus the standard deduction.
For the tax year 2020, the standard deduction for single filers is $12,400, reducing taxable income to $37,275. For tax year 2021, the deduction for single filers will rise to $12,550.
The Bottom Line
The progressive tax system is designed to levy different tax rates on different portions of an individual's income, subjecting only the income above a certain level to the higher rate Your entire income won't be subject to a higher tax bracket.
All in all, a raise is a cause for celebration and not a source of angst.