Your Tax Bracket Is Not The Rate You Pay

I got a raise early in my career and a coworker told me to check whether it had pushed me into a higher bracket, because if it had, I would take home less than before.

I believed him. I sat down that night with a calculator genuinely working out whether I should ask for less money.

He was wrong, mechanically and completely, and I have since heard the same thing from people who process other people's payroll for a living.

How the brackets stack

Federal income tax in the US is progressive, which means your income gets cut into slices and each slice is taxed at its own rate. A bracket is a slice. It is not a label stamped on your whole income.

When somebody says they are in the 22 per cent bracket, the true statement underneath it is that the last dollar they earned was taxed at 22 per cent. Every dollar below that was taxed at a lower rate, and those lower rates do not change when a new slice opens above them.

The rate on your last dollar is your marginal rate. The rate on all of it together is your effective rate. Those are different numbers and people quote the first one thinking it is the second.

One worked return

Meet Dana. Dana is invented and so are these brackets.

• Single filer, no dependents, no other income.
• Gross salary of $70,000 for the year.
• An illustrative standard deduction of $14,000.
• Illustrative rates: 10 per cent on the first $11,000 of taxable income, 12 per cent from $11,000 to $45,000, and 22 per cent on everything above $45,000.

First subtract the deduction. $70,000 minus $14,000 leaves $56,000 of taxable income. That $56,000 is the number the brackets get applied to, not the $70,000.

$1,100 plus $4,080 plus $2,420 comes to $7,600.

Dana is in the 22 per cent bracket. Dana pays $7,600 on a $70,000 salary, and $7,600 divided by $70,000 is 10.9 per cent.

Now the raise

Give Dana $5,000 more. Gross becomes $75,000 and taxable income becomes $61,000. The entire raise sits in the top slice, because new income stacks on top of the income already there.

$5,000 taxed at 22 per cent is $1,100 of extra tax. Total tax goes from $7,600 to $8,700, and Dana's take-home rises by $5,000 minus $1,100, which is $3,900.

Nothing underneath moved. The first $11,000 is still taxed at 10 per cent. The next $34,000 is still taxed at 12. The 22 per cent applies only to the dollars that crossed the line.

The effective rate went from 10.9 per cent to 11.6 per cent. Dana kept 78 cents of every new dollar, and there is no arrangement of the bracket schedule that turns more gross pay into less net pay.

So where does the myth come from

It comes from somewhere real, which is why it survives. There are genuine situations where earning more leaves you worse off. None of them are the bracket table.

• Bonus withholding. Employers commonly withhold supplemental wages like bonuses at a flat rate that can be well above your effective rate, so a $10,000 bonus can arrive looking mauled. That is withholding, not tax. You settle up when you file.
• Benefit and subsidy cliffs. Assistance programmes and health insurance subsidies that phase out over an income range can produce a real cliff where an extra $500 of income costs you more than $500 of support. Those are separate systems with their own thresholds.
• Credit phase-outs. Several tax credits shrink as income rises through a defined range, so the credit you lose can offset part of the raise. The amount still moves in your favour in most cases, just by less than you expected.
• A second job or side income. Each employer withholds as though its paycheck is your only one, so between them they can under-withhold badly and you get a bill in April that feels like a penalty for working more.
• Switching from employee to contractor. Contractor income carries self employment tax that an employer was previously paying half of, which is a genuine increase in the rate on that income and has nothing to do with brackets.

Calculate your own

Pull up last year's return. Find the total tax line and your total income line. Divide the first by the second and you have your effective rate.

Do it a second way with taxable income instead, which strips the deduction out. Dana's second version is $7,600 over $56,000, or 13.6 per cent. Both numbers are useful and both are lower than 22.

Then the marginal rate becomes the number you use for decisions rather than for conversation. It tells you what a pre-tax 401k contribution is actually worth, whether traditional or Roth makes more sense this year, and how much of a side gig's revenue you get to keep.

What the marginal rate is good for

Once you know Dana sits at 22 per cent on the last dollar, a whole set of decisions become things you can price instead of guess at.

A $6,000 pre-tax 401k contribution drops Dana's taxable income from $56,000 to $50,000. Those dollars come off the top slice, so the tax saved is 22 per cent of $6,000, which is $1,320.

So $6,000 lands in the retirement account and take-home pay only falls by $4,680. That is the actual price of the contribution and it is nowhere near $6,000.

Put the same $6,000 into a Roth instead, funded with money already taxed, and it costs the full $6,000 today but comes out untaxed much later. Which one wins depends on whether the rate you pay in retirement is above or below the 22 per cent you are paying now, and since nobody knows that, plenty of people deliberately do some of each.

None of that reasoning works with the effective rate. It only works with the marginal one, which is why both numbers earn their place in your head.

The next time somebody tells you a raise pushed them into a bracket and cost them money, ask them for the two lines off their return. In my experience they have never looked, and the looking is the part that changes how they think about the next raise.