How Federal Tax Rates Work – Not What You May Think
Have you ever heard someone say that “I’m not going to work overtime because it’d put me in a higher tax bracket and I would owe more taxes on all of my income”?
I heard this all of the time when I was working hourly jobs throughout high school and college. I have a feeling the only reason I haven’t heard it since graduating is because I’ve been working in accounting jobs.
Have you ever heard people complain that “The government taxes my bonus checks at a higher rate. even more than they take out of my regular paycheck!”? While more federal tax is withheld, you aren’t actually taxed anymore on this income.
Intrigued or confused? Read on to learn more about why these commonly believed statements are FALSE!
How Federal (Marginal) Tax Rates Work
The United States income tax is based on a marginal tax rate system. What is a marginal tax rate system?
With a marginal tax rate system there are many different income brackets and a different tax rate is applied to each different income bracket. For instance, just the other day I listed the 2013 income tax rate tables that were updated for inflation. Let’s look at an example of a marginal tax rate table for a single person.
Notice how in the table each tax rate is only for a range of income, not all income earned. This is the key to a marginal tax system. If your total income for the year increases into a new, higher tax bracket you won’t pay the new tax rate on all of your income. In fact, you’ll only pay the higher tax rate on the income that is in the new tax bracket .
Let’s go over a quick example to make sure everyone understands how a marginal tax works. Let’s say I make $150,000 of taxable income in 2013 (two words… I WISH!). How much income tax will I owe based on the above table?
First, I’d owe 10% of all of my taxable income up to $8,925 which is a tax of $892.50 on the income in this bracket.
Next, I’d owe 15% of all of my wages in between $8,925 and $36,250 which is a tax of $4,098.75 on the income in this bracket.
Continuing on, I’d owe 25% of all of my taxable income between $36,250 and $87,850 which is a tax of $12,900 on the income in this bracket.
Finally, I’d owe 28% of all of my taxable income between $87,850 and $183,250 which would be $62,150 of income and a tax of $17,402 on the income in this bracket.
The last step is to add up the income tax owed from each bracket ($892.50 + $4,098.75 + $12,900 + $17,402) for a total tax owed of $35,293.25.
In this example, if I earned $1 more in 2013
it would be taxed at 28%. However, my effective tax rate is only 23.5%. The effective tax rate is calculated by taking total tax owed divided by taxable income for the year ($35,293.25 divided by $150,000).
The “It Will Put Me In a Higher Tax Bracket On All of My Income” Fallacy
Some people don’t understand marginal tax rates. If the above statement were true and you made $8,925 you’d owe $892.50 in taxes. Now, if you made one more dollar, $8,926, this person would think they’d owe 15% on all of their income for a total of $1,338.90. Luckily, this isn’t how marginal tax rates work.
It should be clear now that working more hours or working overtime will NOT put all of your income into a higher tax bracket like in the example directly above. It may put any additional dollars you earn into a new tax bracket, but it will NOT put all of your income in the new bracket.
Yes, you will get to keep less of the extra money you earn when you file your taxes. However, isn’t paying taxes on your additional dollars at the new tax rate better than not working the extra hours and earning (and keeping) nothing? I’d say it is, assuming you would want to work the hours to get extra money anyway.
“The Government Taxes My Bonus Checks at a Higher Rate” Fallacy
Have you ever gotten a bonus, looked at your check and wondered why it has so much taken out in federal taxes? There is an easy answer for that! The IRS allows employers to withhold federal tax at a flat 25% rate on all bonus checks regardless of your filing status and exemptions that you submitted on your W-4. Check it out straight from the IRS’s mouth… or website .
So, yes, the government does withhold more federal income tax (in some circumstances) than in a normal paycheck. However, the IRS doesn’t keep this money if it isn’t warranted (if it is indeed extra withholding).
It is very possible that when you file your tax return at the end of the year you could get a refund for the money withheld above what you actually owed on your bonus check. Of course, if you didn’t have enough money withheld throughout the year the extra money that was withheld from your bonus check will instead reduce what you owe.
See, the government doesn’t tax your bonus check at a higher rate, it just withholds federal income tax at a higher rate. If you don’t owe the money you’ll get it back when you file your tax return.
So does the marginal tax rate system that the United States uses make more sense now? Do you understand why these two common statements made above normally aren’t true? If not let me know and I’ll do my best to explain further!Source: www.moneymanifesto.com