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Bumped Into A Higher Tax Bracket - Now What?

Have you ever wondered what happens if you get a raise or promotion and now you all of a sudden find yourself in a new tax bracket. If you're like most people you get a little bit irritated because now you're paying more of your income to Uncle Sam. When I worked as a kitchen manager at a family restaurant I would turn down opportunities to become an assistant manager because I didn't want to get bumped into the next tax bracket. The way I saw it, getting a promotion would end up in a net pay cut.

I was wrong.

Tax Waterfall

Tax brackets aren't an all-or-nothing deal. If our income jumps to the next bracket - say, from 12% to 22% - that doesn't mean that our entire income (technically taxable income but I'm keeping this simple for demonstration purposes) is taxed at 22%*.

Instead, the tax system works like a waterfall. If you think of your income as a stream of water that flows into a cup marked 10%, once that 10% cup is filled the water overflows into a new cup that is marked 12%. You are always going to pay just 10% on that first cup. The 12% rate gets applied to the second cup. Once the second cup gets filled it overflows into a third cup marked 22%. Now you have one full cup getting taxed at 10% and a second full cup taxed at 12%. Only the overflow in the third cup is taxed at 22%. This process continues until you get to the top rate, when everything over that break point is taxed at the top rate.