Here’s something I overheard a few years ago that broke my heart.
“I may as well not make more money, the government will just increase my tax rate so I’ll end up with less.”
Taxes don’t work that way.* To see how they work, let’s take a look at a tax schedule:
|TABLE 3 – Section 1(c) – Unmarried Individuals (other than Surviving Spouses and Heads of Households)|
|If Taxable Income Is:||The Tax Is:|
|Not over $8,375||10% of the taxable income|
|Over $8,375 but not over $34,000||$837.50 plus 15% of the excess over $8,375|
|Over $34,000 but not over $82,400||$4,681.25 plus 25% of the excess over $34,000|
|Over $82,400 but not over $171,850||$16,781.25 plus 28% of the excess over $82,400|
|Over $171,850 but not over $373,650||$41,827.25 plus 33% of the excess over $171,850|
|Over $373,650||$108,421.25 plus 35% of the excess over $373,650|
|Source: Rev. Proc. 2009-50, page 8|
So, let’s see how this works. Look at the first row. Reading the chart, we’ll see that “If taxable income is not over $8,375, the tax is 10% of the taxable income. So, let’s say you make $5,000 in taxable income. Since it’s less than $8,375, that means the calculation is $5,000 times 10%, which is $500 in tax.
Now the next row. “If taxable income is over $8,375 but not over $34,000, the tax is $837.50 plus 15% of the excess over $8,375.” Now we start to bump into confusion land. For example, say you make $10,000 in taxable income. Well, that’s certainly over $8,375 but not over $34,000. Now, how do you calculate your tax?
I like to look at the calculation backwards, as it simplifies things greatly. So, we find the excess over $8,375, which we calculate as $10,000 minus $8,375, which is $1,625. Since $1,625 is the excess over $8,375, we then multiply $1,625 by 15% to get $243.75. Now, we take that $243.75 and add it to $837.50 to get $1081.25, your tax.**
So, you can see why hearing that made me feel for this person. You can see from the table above that earning more money, increasing your taxable income, doesn’t increase your tax to the extent that it becomes sensible to earn less taxable income. Marginal rates mean that, as you move up to a higher bracket, it’s only the money earned in a bracket is taxed at a higher rate. Money earned in the 10% bracket is taxed at 10%, when you make the next dollar that moves you into the 15% bracket, that dollar is taxed at 15%, but the dollars previously earned in the 10% bracket are still taxed at 10%.
And let’s also remember that taxes are calculated as a percentage of your taxable income, and that percentage hs never been 100%.
*Ok, there may be some minor exceptions that have to do with refundable credits, but that doesn’t apply to most people..
**Remember, though, if you do your taxes by hand, follow all instructions in your tax booklet, including the instructions on looking up your taxes owed by referring to tax tables.