How much does it really cost you to move into a higher tax bracket?
Myths and misconceptions about the tax code are rampant and clients frequently express their concerns about a variety of tax-related issues. One topic that comes up frequently is our federal government’s graduated tax bracket system. Oftentimes, people worry that if they make “too much” money, their entire income will be taxed at a higher rate – a worry that has kept countless hard-working taxpayers up at night. But are these concerns valid? Hopefully, by diving into the issue of how much it actually costs to move into a higher tax bracket, I can provide some reassurance.
Getting To Know The Graduated Tax Bracket System
Most taxpayers understand that our tax bill is determined by how our income is classified within the federal government’s tax bracket system, which is why it’s easy to conclude that those who have higher incomes will be taxed at a higher rate – determined by their tax bracket. But that simple explanation only tells part of the story. Sure, higher income plays a large role in determining your tax bracket. But so does the manner in which you file – “single,” the “head of household,” “married filing jointly,” or “married filing separate.” Once your tax bracket has been determined, however, a greater misunderstanding concerning the “graduated” manner by which your income is taxed comes into play.
Simply put, while all taxpayers will fall into one of the following tax brackets: 10 percent, 15 percent, 25 percent, 28 percent, 33 percent and 39.5 percent; your designated taxable percentage will not be assessed to your entire income.
Tax professionals will often hear that their clients “don’t want to earn too much money” in fear that they will be reassigned to a higher tax bracket and all their income will be taxed at a higher rate. Ultimately, they don’t want their tax payments to sharply increase simply because they made a little more money this year than they had in previous years. If this were the case, I would be worried about making “too much money” too, but because our tax bracket system is “graduated,” this is not the case.
For example, just because you made an extra $1,000 this year and were bumped up to the 28 percent tax bracket this year doesn’t mean that your entire income will now be taxed at 28 percent – only that last $1,000 will be taxed at the higher rate. The rest of your income will continue to be taxed as it had been in previous years – in graduated stages.
The Break Down
Let’s assume that you are getting ready to file your federal income taxes and your tax status will be “married filing joint.” Based on your filing status, wages, etc., your accountant has concluded that your taxable income comes to $160,000. Even though your taxable income lands you in the 28 percent tax bracket, different portions of your income will be taxed at different rates. Based on the $160,000 figure, your income will be taxed as follows:
- First $18,450 is tax at 10 percent
- Next $56,450 is taxed at 15 percent
- Next $76,300 is taxed at 25 percent
- The Final $8,800 is taxed at 28 percent
I tell clients that until the federal government establishes a 100 percent tax bracket, you are almost always better off earning more money. In other words, don’t let the tax bracket myth stop you from earning what you are worth.
Exceptions To The Tax Rules
Hopefully the information provided above gives you greater insight into our system of tax brackets and how multiple percentages are used to determine your final tax bill. While the graduated tax bracket system is pretty standard, there are times when different methods are applied – and these methods will reinforce the claim that it costs more to earn more. For example, if you pay the alternative minimum tax (AMT) instead of adhering to the graduated tax brackets, you could be playing a flat 26 percent or 28 percent income tax rate. Because this flat rate is applied to your entire income, you end up paying a larger tax bill. Another way in which you may wind up paying more to the government based on your tax bracket is if your income exceeds phase-out thresholds on certain tax incentives, such as the child tax credit and college tuition tax credits (American Opportunity Tax Credit and the Lifetime Learning Tax Credit). But, again, depending on how much more you stand to earn over the specified phase-out limit, it may still benefit you to earn more income.
Tax situations can vary widely from one individual to another and the best course of action is to discuss your unique situation with a certified tax professional. Email Rea & Associates to learn more about graduated tax brackets and steps you can take today to invest in your financial wellbeing.
By Mark Fearon, CPA (New Philadelphia office)