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 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.
This happens quite a bit. You might be shocked to learn how often this misunderstanding happens. I have been in meetings with wealthy clients who were worried about getting pushed into the next tax bracket; this confusion covers everyone. If you made this mistake like I did, you are not alone.
I really dislike using jargon, but I think it might be useful to talk a little bit about what all those different tax words mean when people start talking taxes? The rates that we most often see are called marginal tax rates. Marginal meaning incremental. So every incremental dollar is taxed at the marginal tax rate. If you are in the 32% marginal tax bracket, then the next dollar you earn** is taxed at 32%.
Effective tax rate is from a calculation. Take your taxes paid and divide by your taxable income. The numerator of that formula will incorporate all the different marginal tax rates. It's the average tax rate you paid. Going back to the example of using cups, the effective (aka average) tax rate will be close to the cup with the most water in it.
Most people are thinking about effective or average tax rates when they read or hear about marginal tax rates. Hearing a percentage and wanting to apply that to your whole income is natural.
If you're ever in a situation like I was where you are evaluating a promotion, a raise, a second job, or any other kind of income opportunity, the way to analyze whether that makes sense for you is to look at how much you get to keep from any additional money you make, not by thinking about it in terms of getting bumped into a higher tax bracket. That higher tax bracket only applies to money that hasn't yet filled up the rest of the buckets.
* The actual tax rates I used change. For example, last year the tax rates were different from this year and are likely to be different in the future. The concept still applies no matter what the actual numbers are, though.
** I'm simplifying this by saying "earn." The actual numbers that are used to calculate taxes are from taxable income - but a discussion about taxable income is beyond the point of this post.
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