One of my readers, Annie, writes:
I am up for a promotion at work, but a coworker says that I shouldn’t try to get the job because it will put me in a higher tax bracket. Is this something I should worry about? Would I actually make less money after getting a raise?
Don’t sweat the small stuff, Annie, and go for the promotion. You will bring home more money after getting promoted, even if it does bump you into another tax bracket. Your coworker is either misinformed or is trying to convince you not to go for the promotion. Here’s why.
A Quick Primer on Tax Brackets
At the end of the year, when you do your taxes, you’re actually calculating a number called your taxable income. This is the amount of income you brought in that the government actually takes income tax out of. The higher that number, the higher tax bracket you find yourself in.
For example, let’s say you’re a single person. In 2006, the United States federal tax brackets were:
10%: from $0 to $7,550
15%: from $7,551 to $30,650
25%: from $30,651 to $74,200
28%: from $74,201 to $154,800
33%: from $154,801 to $336,550
35%: $336,551 and above
If you make $50,000 in taxable income, then $7,550 is taxed at 10%, $23,100 is taxed at 15%, and the rest, $19,350, is taxed at 25%. That means you pay a total of $9,057.50 in income tax. $40,942.50 is yours to keep.
Now, if you got a raise and made $60,000 in taxable income, then $7,550 is taxed at 10%, $23,100 is taxed at 15%, and the rest, $29,350, is taxed at 25%. Notice that there’s only one difference here: that extra $10,000 is taxed at the 25% rate, but nothing else changes. You pay a total of $11,557.50 in income tax, and $48,442.50 is yours to keep. Your raise, after taxes, is $7,500.
Understanding tax brackets can explain a few things:
Tax deductions are more lucrative for high income people than low income people. If you only have $30,000 in taxable income, you’re only paying 15% at most on your income, so sweating it out for a $2,000 deduction saves you only $300. However, if you’re in the 35% bracket, that same $2,000 deduction saves you $700. That’s a $400 difference, so the higher income people generally get more benefit from deductions.
Tax withholdings from your paycheck are based on your pay rates and the tax brackets. This information is usually supplied by the IRS and is based on your salary and the number of dependents you claim (which are deductions). This gives a thumbnail of what you’ll be taxed on so your employer can keep out an appropriate amount of money. Altering your number of deductions changes the size of the withholdings because if you claim fewer dependents, your taxable income appears to go up, and if you claim more dependents, your taxable income appears to go down.
“Extra” income is always taxed at the highest rate. Let’s say you’re in the 28% tax bracket and you happen to make an extra thousand dollars doing some consulting work. That money is taxed at 28%, so you’d better be saving 28% of it for tax day. This is often why people end up paying more on their taxes come April – they earned some extra income.
To summarize, Annie, don’t fear the tax bracket – more earnings are always better.