How Do Tax Brackets Work?

There is a persistent misunderstanding about tax brackets. It starts with the (true, but oversimplified) statement that “higher incomes are taxed at higher rates”. That leads to the popular misconception that your income determines your rate, and the rate is then applied to your income. And this leads to all sorts of unnecessary worries about “going into another bracket”. Which have the potential to lead to financially dubious strategies, like refusing income or seeking expensive deductions. Here’s an illustration of the misunderstanding. Suppose the tax brackets are: $0 – $9,875: 10% $9,875 – $40,125: 12% $40,126 – $85,525: 22% Suppose you make $40,000 taxable income. That puts you in the 12% bracket. 12% of $40,000 is $4800 in tax. But if you make another $1000, your income is $41,000, and you are in the 22% tax bracket. 22% of $41,000 is $9020. So you see, that adding $1000 of income resulted in $4220 more in taxes, and you actually lost $3200! So, you should be very, very careful not to make too much money! That last paragraph was completely, and utterly WRONG. Yet, it represents the common naive understanding of tax brackets. Now I will illustrate again, using the correct application of tax brackets. Suppose you make $40,000 taxable income. The first $9875 is taxed at 10%, for $987.50. The next $30,125 falls into the 12% bracket, and is taxed at 12%, for $3615. The total tax is: $4602.50. Note that you are not paying 12% on your income. The “effective rate” is a little less: about 11.5%. Now suppose you make another $1000. $125 of that still falls under the 12% bracket and is taxed at 12%, or $15. The remaining $875 is in the 22% bracket resulting in $192.50 more in taxes. Grand total: $4810. Which is an “effective rate” of 11.73%. Even though you “went into” a new tax bracket, and jumped from 12% to 22%, the tax increase was $207.50. Your take-home pay is $792.50 more after the income increase. Or, to put it another way, your income increased 2.5%, but your effective tax rate increased 0.23%. That’s the basic idea. In most cases, if you make more, you pay more; and you pay a higher percentage. But you also take home more. You might turn down the extra work if $792.50 is too little pay for $1000 worth of labor, but you don’t turn it down because of any risk of losing money due to tax brackets.

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