Friday, May 6, 2011

Myth Buster: Why Tax Brackets Cannot Hurt you

Every time I talk to someone, either in person or online, about increasing their earnings I get some sort of comment about how they must first make sure they won't get bumped into a higher tax bracket. Everyone, including myself until a few years ago, seems to think that is possible to take home less money after getting a raise or a second job because more earnings means a higher tax bracket and thus more money going to the government. This is just plain wrong and is holding many people back from bumping up their income.

The phrase "tax bracket" is really a misnomer and has lead to misunderstanding of the way the U.S. tax system works. There is no flat tax bracket that is applied to all of your income. Instead, there is a marginal tax bracket system. This means that only your income above a certain level is taxed at the higher rate. So as you earn extra income you pay more per dollar of that extra income in taxes, but your base income is still taxed at the same rate.

Here is an example:
Let us say I eanred $100,000 of taxable income (I wish!) in 2009. This table does NOT mean that I pay 28% of my income, $28,000, in taxes.

On my first $8,350 I would pay 10%, $835.
On my next $25,600 I would pay 15%, $3,840.
The next $48,300 would be taxed at a rate of 25% for a total of $12,0775.
My final $17,750 would be taxed at 28%, $4,970.
My total tax bill would be $21,720.

People would refer to me as being in the 28% tax bracket when only a small portion of my total income was taxed at that level. Someone else who earned only $8,350, would pay the same $835 on that money as I did.

It is impossible for this system to lead to a decrease in your after taxes pay this year as compared to last year just because you increased your earnings.  So stop using this as an excuse! Get out there and get those extra earnings!

What the marginal tax bracket system does show is that sometimes there is dminsihing returns on your effort/earnings. As you earn more, you make less for each additional dolar. This means you may want to calculate if the effort needed to earn a given amount of cash is justified by the after taxes pay you will receive for it. That goes for any job you take - even if it was tax free. You must always calculate if you are being compensated adequately for your time.

Before someone's makes an irate post about how earning more is going to cost them their "programs" and thus it is irresponsible of me to advise them to increase their income let me address this issue: Increasing income can  boot people from eligibility for certain government assistance programs. In my opinion this is not a bad thing. These programs exist to help people who are either incapacitated due to severe disability or who are struggling to find work. As people find work they should no loner be eligible for assistance. If you are able bodied and can work and provide for yourself you should not be allowed to choose to stay home and live off others tax money. What if we all did that? There would be no money left for those struggling families dealing with a disability or a recent lay-off. Loosing eligibility means you have managed to to get back on your feet. It should be looked upon as a victory, not as a loss. I do not look down on any family that is struggling and seeking work but failing to find it. We live in tough times. But choosing not to work or to even try and look for ways to live frugally and bring in income because it is easier to live off "programs" is just immoral. If you are in that situation, and prefer to remain that way,  this blog is not for you.


Rachelli said...

Thanks for the clarification - I never realized it worked this way. I've never used tax brackets as an excuse for earning less, because I figured I'd have to be at the border to be earning less, and that would even be worth it as a step on the ladder... but turns out it works out ok regardless.

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