You Still Make More Money, Even in a Higher Tax Bracket

I’m at the top of the tax bracket - if I earn any more money, I’d actually take home less because of the higher tax rate.

This is a common thought process, especially in regards to raises or bonuses, or when deciding whether to work overtime. Some will actively avoid being paid more money due to the fear of losing all of that extra money and more to taxes if they were to be pushed into a higher tax bracket.

Is this concern valid?

No. Let’s dive into why.

What is Income Tax?#

Income tax is a portion of your paycheck that is paid to the government. The size of that portion is based on how much money you make, and in many cases, where you live.

The United States uses a progressive tax system. The way this works is: incomes are divided into ranges, with each range corresponding to a certain income tax rate. The higher the range of incomes, the higher the tax rate. These ranges are known as tax brackets.

In other words, the more money a person makes, the more they pay in taxes, both in terms of the actual dollar value and as a percentage of their income. As a person’s income increases, the percentage of that additional income that is taxed also increases.

For example, a single person making $10,000 per year in 2020 finds themself in the 12% tax bracket. Meanwhile, someone earning $50,000 per year in 2020 finds themself in the 22% tax bracket. A full list of the tax brackets for 2020 can be seen here.

The Misconception#

Tax brackets may seem pretty straightforward, but a major misconception begins to take form as a person’s income approaches the upper end of a bracket.

Notice that for the year 2020, a single person (Bob) at the very top of the 12% bracket is making $40,125 per year. Meanwhile, someone else (Alice) earning just one additional dollar, for a total salary of $40,126, is in the 22% tax bracket.

Quick math would suggest that Bob is paying $40,125 x 12% = $4815 in income tax, while Alice is paying $40,126 x 22% = $8827 in income tax, or $4012 more than Bob. This would result in Alice taking home less money than Bob despite being paid more.

But this is incorrect.

The Reality#

The results above stem from the misconception that the tax bracket a person is in applies to the entirety of their income. In reality, the rate of a tax bracket only applies to the income earned within that tax bracket.

Let’s apply this to Alice and Bob above. Recall that Bob earns $40,125, which is in the 12% bracket. But the 12% bracket only applies to income from $9876 to $40,125. For income between $0 and $9875, the income tax rate is 10%. So Bob pays 10% income tax on $9875 of his income, and 12% on the remaining $30,250, for a total tax bill of $4617.50.

Meanwhile, Alice, who is paid one dollar more, finds herself in the 22% tax bracket. She pays the same $4617.50 on the first $40,125 that Bob pays. But since she earns another dollar, that one dollar is taxed in the 22% bracket. She pays 22 cents of tax on that last dollar, for a total tax bill of $4617.72.

Alice’s gross (before-tax) income is one dollar larger than Bob’s, but her tax bill is only 22 cents larger. So her pay after subtracting income tax is 78 cents more than Bob’s, despite her marginal tax bracket being siginificantly higher than Bob’s.

It’s important to note that there are other expenses that further reduce the amount of money that Alice or Bob will ultimately receive. In this article, we are only focusing on federal income taxes, as that is the basis of the misconception mentioned previously.

Conclusion#

It is never the case that being paid more money will actually result in receiving less money due to moving to a higher tax bracket. In order for this to be true, the income tax rate of that tax bracket would have to be close to 100%.

So the next time someone says they’re turning down a raise, or a promotion, or overtime because they don’t want to be pushed to a higher tax bracket, you can gladly offer to take it instead.