Once people learned I was an accountant early in my career, I often had a few acquaintances ask me questions in the weeks leading up to tax day. I have learned a great deal from the questions I have been asked. Federal income taxes in the United States are extremely complex. I’m not surprised so many people don’t understand how our tax system works. However, I was surprised by what I think is one of the largest misconceptions about our income tax system.
Note: All tax brackets in this article are for illustrative purposes only and are not the current tax brackets as issued by the IRS.
How People Think Tax Brackets Work
Just a few weeks ago I hired a plumber to make a repair at a property we were selling. We were talking about his busy schedule and how his boss was forcing him to work overtime. He liked the money, but was concerned that earning too much money due to the overtime would cause him to go up to the next tax bracket and greatly reduce his tax refund. In fact, he was so worried he said he’d quit his job once he hit his targeted income for the year to preserve his tax bracket status.
I spoke with the plumber for quite a while to try to understand why he was worried. I quickly discovered he thought going into the next tax bracket meant all of his income would be taxed at that new rate. For instance, the plumber thought if he earned $39,999 and was in the 10% tax bracket, he’d only owe $3,999.99 but if he earned $40,000 and was put into the 15% tax bracket he’d owe $6,000. Fortunately, that’s not how the United States federal income tax bracket system works.
How Tax Brackets Really Work
The federal income tax system works based on marginal income tax rates. Essentially, a marginal income tax system works by taxing you on each additional dollar of income you earn, not your entire income. As you move up to a higher tax bracket, only the additional income you earn in that higher bracket will be taxed at the higher rate. This is much easier explained using a quick example.
For this example, the tax brackets are as follows:
$0 to $9,999 – 0%
$10,000 – $19,999 – 10%
$20,000 – $39,999 – 15%
$40,000 – $74,999 – 25%
$75,000 and up – 30%
Let’s pretend Bob will make a $30,000 salary this year. If you’re like the plumber that came to my house a few weeks ago, you’d think Bob would owe 15% on his total salary of $30,000 for a total tax bill of $4,500. Thankfully, that isn’t how it works.
Based on the above tax brackets, he would pay $0 on his first $9,999 of income, he would pay 10%, or $1,000, on his next $10,000 of income, and 15%, or $1,500, on the last $10,000 of income. His total tax owed would be $2,500. If Bob earned a bonus and made over $39,999, only the income above $39,999 would be taxed at 25%.
You Are Taxed More as You Earn More
The marginal tax system works in an interesting way. The more money you earn, the more taxes you pay on that money. This makes sense to help people not earning as much to keep more of the money they earn. However, it also means people have less incentive to earn each additional dollar.
When you’re earning income in the 15% tax bracket, you get to keep 85% of the money. However, if you’re in the 25% tax bracket, you only get to keep 75%. As tax brackets continue increasing, you have to evaluate if it is worth your effort to make more money while keeping less. Personally, I always say earning more income is a good. Yes, I keep less, but I may not have to put in as much effort to earn the additional income.
Other Tax Considerations
Taxes are way more complex than a simple marginal tax bracket. There are many, many deductions, credits and other tax items that change based on how much income you earn. As your earnings increase, you generally qualify for less tax deductions and credits. In fact, some deductions and credits completely go away if you make too much money. For that reason, it is important to talk to a tax professional to make a customized plan for your specific tax situation. At least your tax person won’t have to explain how the marginal tax system works.
Unfortunately, if you only visit a tax professional at tax filing time, it may be too late. Many tax planning strategies only work if you have time to make adjustments. If the tax year is over, there are very few adjustments you can make. At least your tax person won’t have to explain how the marginal tax system works.
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