Most people don’t understand taxes. This is understandable because our tax code is messed up and confused. However, there is one concept that many people get wrong and is fairly easy to explain: tax caps.
The “Take more with you while earning less” fallacy
You may have heard someone boast that they have managed to make more money by earning less. This person will claim that by cutting his salary, he somehow received an increase in his salary. They will claim that this is because they were lowered into a lower tax bracket. Or, on the contrary, what did they do less earning morebecause they were moved to a higher tax bracket.
In fairness, it should be noted that in some circumstances, less earnings will not have a proportional effect on your wages. But this usually happens at very low income levels. For example, when accounting for tax credits and other government assistance, a single parent who earns $21,000 can only get home $1,967 more than a single parent who earns only $4,800 despite earning $16,200 more in wages, according to a report from The Tax Foundation.
But this is due to loans and government assistance, No tax brackets.
The myth that you can take home more by earning less suggests that right at the borders between the various brackets, people can either be fined for being just above the line or rewarded for being just below the line. A 12% tax rate on $40,000 is a better deal than a 22% tax rate on $45,000.
And, at first glance, the math backs it up: 12% of $40,000 is $4,800, and 22% of $45,000 is a whopping $9,900.
But that’s not how tax brackets work.
Tax brackets tell you your marginal tax rate
Although people usually talk about being in one tax bracket or another, this does not mean that this percentage – whether it be 12%, 24% or 37% – applies to their the whole income.
Rather, it is their marginal tax rate.
marginal taxes refer to taxes applicable to the most recent dollar you earned in a given year. So your marginal tax rate is the tax rate applied to the last money you have, or the last dollar you have, that exceeds a certain threshold. (If you think of your income as a big mountain, your marginal tax rate will only apply to the top of it.)
Read more: 2022 income tax brackets
Practical examples of marginal tax rates
The first $10,275 of a $100,000 annual hedge fund manager income is taxed at the same rate of 10% as the first $10,275 of a $25,000 annual income of a fast food worker or a dental hygienist’s annual income of 75 thousand dollars.
The next $31,500 is taxed at a rate of 12%, regardless of the individual’s total annual income. And so on and so forth until the last parenthesis, which starts at $539,901. Anything above $539,900 – but nothing underneath taxed at a rate of 37%.
So, back to our first example: from a tax standpoint, making $40,000 a year is no better than $45,000. Because the first $10,275 of that $45,000 will be taxed at a rate of 10%; the next $31,500 will be taxed at 12% and only the last $3,225 will be taxed at 22%.
The poor fellow who turned down a pay raise and stuck to a $40,000 annual salary would pay about $4,594.5 in taxes and take home $35,405.5 in his salary. The smart guy who gladly accepted a raise to $45,000 would pay about $5,517 in taxes and take home $39,483 in his salary. Boo me!
Your real tax rate is your effective tax rate
When People Talk About Tax Rates, What They Really Mean effective tax rate. This is the actual tax rate you pay after you account for everything on your tax return: benefits, deductions, credits, and so on.
You can find the effective tax rate by taking the total amount of tax on your tax return and dividing it by your total income. This can vary greatly depending on a number of circumstances – whether you have children, whether you have a mortgage, whether you are in school, whether you invest in the stock market – and it is difficult to predict.
You may recall how Warren Buffett denounced certain tax laws that caused his effective tax rate to be lower than his secretary’s, despite the fact that his marginal tax rate is clearly higher than her secretary’s. This is due to the many loopholes and the fact that capital gains are usually taxed at a significantly lower rate than some of the higher marginal tax brackets. (There’s also “withholding interest” that helps hedge fund managers pay a lower effective tax rate, but I’m worried I’m boring you enough.)
Marriage makes taxing harder, but the math still holds
With married couples, the marriage bonus, and the marriage penalty, the tax brackets get a little shaky, and the amount that different spouses earn can affect their tax rates. Due to some random quirks in brackets for married couples, some people may pay more taxes as spouses than as singles, and some people may pay less.
This is because the tax brackets for married couples are not always the tax brackets for singles times two. For example, in 2017, while the threshold for the 25 percent singles group was $91,900, the threshold for a married couple applying jointly was only $153,100 (not $183,800, which is double the single bet).
This tax year, if two people who each earn $85,000 were married, they would pay $34,484.5 in combined taxes. Had they remained single, they would have paid $33,977.5 in cumulative taxes on the $507 difference.
As the saying goes, that was then and this is now. Most of Current the tax brackets for married couples are the equivalent of the figures for singles multiplied by two. This may change in the future.
“Marriage Bonus”
Couples in which one partner earns significantly more than the other often receive a “marriage bonus” where income that would be taxed at a higher rate for singles is taxed at a lower rate for spouses due to larger groups.
Let’s say spouse A works full-time and earns $50,000, while spouse B works part-time and only earns $20,000. If they were to apply for 2022 as singles, then the marginal tax rate for Spouse A would be 22% and Spouse B would be 12%. In total, they would have paid $11,005.66 in taxes.
However, as a married couple, Spouse A and Spouse B’s marginal tax rate will be only 12% of both of their incomes combined, and they will pay only $7,988.88 in taxes. This is a very significant difference 3016.78 USD.
Read more: Financial Benefits of Marriage
Summary
Our tax system certainly has its quirks and inconsistencies. But in none of the examples above, earning less money resulted in more cash after taxes.
So don’t think twice before accepting this upgrade.
