Most people don’t understand taxes. This is understandable, because our tax code is arcane and convoluted. However, there’s one concept that lots of people get wrong that’s pretty easy to explain: tax brackets.
The take-home-more-by-earning-less fallacy
You’ll sometimes hear someone boast that they managed to take home more money by earning less of it. This person will claim that, by taking a cut in salary, they somehow got a raise in their take-home pay. They’ll claim it’s because they were bumped down into a lower tax bracket. Or, by contrast, that they made less by earning more, because they were bumped up into a higher tax bracket.
To be fair, there are some circumstances in which earning less will not have a proportional impact on your take-home pay. But this typically happens at very low income levels. For example, when accounting for tax credits and other government assistance, a single parent who earns $21,000 could take home only $1,967 more than a single parent who earns only $4,800, despite earning $16,200 more in wages, according to a November 2015 report by The Tax Foundation.
But that has to do with credits and government assistance, not tax brackets.
The myth that you could take home more while earning less assumes that right at the borders between the different brackets, people can be either penalized for being slightly above the line or rewarded for being slightly below. That getting taxed at 15 percent on $37,450 is a better deal than getting taxed at 25 percent on $38,000.
And, on its face, the math supports it: 15 percent of $37,450 is $5,617, while 25 percent of $38,000 is a whopping $9,500. (Let’s put aside, for the moment, deductions, credits, and other such minutia of the tax code, which, as I said earlier, is arcane and convoluted.)
But that just isn’t how tax brackets work.
Tax brackets tell you your marginal tax rate
While people commonly talk about being in this or that tax bracket, that doesn’t mean that that percentage—whether 15 percent, 25 percent, or 39.6 percent—is applied to their entire income.
Rather, that’s their marginal tax rate.
Marginal, in economics, means “additional.”
Marginal cost refers to the cost of producing one more of a certain item. Marginal taxes refer to the taxes applied to the very last dollar you earned in a given year. So your marginal tax rate is the tax rate applied to the last of your money, or the last of your dollars that exceeded a certain threshold. (If one were to visualize your income as a big mountain, then your marginal tax rate would apply only to the topmost part of it.)
Everybody’s money is taxed at the same rate, regardless of total income
The first $9,225 of a bond trader’s income is taxed at the same rate—10 percent—as the first $9,225 of a fast food worker’s income, or a dental hygienist’s. The next roughly $28,000 is taxed at 15 percent, regardless of how much total money someone makes. And so on and so forth until the last bracket, which starts at $413,201. Everything above $413, 201—but nothing below it—is taxed at 39.6 percent.
To go back to our first example, it’s not actually better to make $37,450 and get taxed at 15 percent. Because $37,450 of that $38,000 will be taxed at 15 percent, or $5,617. That last $550 (that is, the amount in addition to $37,450, the cut off between brackets) will be taxed at 25 percent, or $137, but that still leaves you an additional $413, with which you could buy an Xbox or a really fancy pair of shoes.
Your real tax rate is your effective tax rate
When people talk about tax rates, what they’re really talking about is their effective tax rate. This is the actual tax rate you pay after you factor in everything on your tax return: exemptions, deductions, credits and so on.
You can find your effective tax rate by taking the total tax on your tax return and dividing it by your total income. This can vary wildly based on a number of circumstances—whether you have kids, whether you have a mortgage, whether you’re in school, whether you invest in the stock market—and cannot be easily predicted.
You may recall Warren Buffet decrying certain tax laws that made his effective tax rate lower than his secretary’s, despite the fact that his marginal tax rate is undoubtedly higher than hers. This is due to lots of loopholes, and the way that capital gains are usually taxed at a considerably lower rate than some of the higher marginal tax brackets. (There’s also the “carried interest” thing that helps hedge fund managers pay a lower effective tax rate, but I worry I’m boring you enough as it is.)
Marriage makes taxes trickier, but the same math still applies
With married couples, and the marriage bonus and marriage penalty, tax brackets get a little wonkier, and the amount different spouses make can have an effect on their tax rates. Because of some quirks in the brackets for married couples, some people may pay more tax as spouses than they would have as singletons, and some people may pay less.
This is because the tax brackets for married couples aren’t just the tax brackets for singles multiplied by two. (Or, rather, not all of them are.) For instance, while the cut off for the 25 percent bracket for singles is $90,000, the cut off for a married couple filing jointly is only $151,000 (not $180,000, twice the single rate).
If two people each earning $85,000 get married, then about $19,000 of their collective dollars ($85,000 x 2 = $170,000 – $151,000 = $19,000) will fall in the 28 percent bracket that, had they remained single, would have been taxed at 25 percent, costing them about $570.
Couples where one partner earns considerably more than the other often get the marriage bonus, where income that would have been taxed at a higher rate is taxed at a lower one because of the larger brackets.
Related: The Financial Benefits of Marriage
Let’s say Spouse A works full time and earns $50,000, but Spouse B works part time and only makes $20,000. Had Spouse A filed as a single person, then his or her marginal tax rate would have been 25 percent, which would have applied to $12,550 of their income. However, as a married couple, Spouse A and Spouse B’s marginal tax rate is 15 percent (the cut off for the 15 percent bracket for married filing jointly is $75,000), a savings of about $1,254. (As you’ll notice, the switch from the 15-percent bracket to the 25-percent bracket is a bigger deal than the switch from 25 to 28 percent.)
In none of these cases, however, could earning less money have resulted in taking home more cash.
A smaller percentage of a larger number will always be more than a larger percentage of nothing.
It’s possible, of course, that a lower tax rate can take some of the sting out of making less money. The key decision here is not whether you make more or less money, but rather whether you get married, a decision that isn’t usually taken up solely as a means of tax avoidance.