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 may have heard 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 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 12% on $40,000 is a better deal than getting taxed at 22% on $45,000.
And, on its face, the math supports it: 12% of $40,000 is $4,800, while 22% of $45,000 is a whopping $9,900.
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 12%, 24%, or 37% — is applied to their entire income.
Rather, that’s their marginal tax rate.
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 glacier, then your marginal tax rate would be the portion sticking out of the water.)
Practical Examples of Marginal Tax Rates
The first $11,000 of a hedge fund manager’s $100K annual income is taxed at the same rate — 10% — as the first $11,000 of a fast food worker’s $25K annual income or a dental hygienist’s $75K annual income.
The next $33,725 is taxed at 12%, regardless of a person’s total annual income. And so on and so forth until the last bracket, which starts at $578,125 for single filers. Everything above $578,125 — but nothing below it — is taxed at 37%.
So, to go back to our first example, it’s not actually better tax-wise to make $40,000 per year than it is to make $45,000. Because the first $11,000 of that $45K will be taxed at 10%; the next $33,725 will be taxed at 12%, and only the final $275 will be taxed at 22%.
The poor sap who refused a pay raise and stuck to a $40K annual salary will pay around $4,580 in taxes and take home about $35,420 in pay. The smartie who gladly took the raise to $45K will pay around $5,208 in taxes and take home around $39,792 in pay. Boo-yah!
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. But in 2023 and for the 2022 tax year, the singles bracket is exactly half of the joint couples’ bracket for everything below 37%.
For example, in 2023, the cut-off for the 22% bracket for singles is $95,375 and the cut-off for a married couple filing jointly is $190,750 — exactly twice the singles bracket.
The 37% tax bracket is the only one with quirks. Instead of being double the single’s cut-off, the maximum for married couples is much lower. For 2023, incomes greater than $578,125 have a marginal tax rate of 37% for single filers while incomes greater than just $693,750 for married couples have a marginal tax rate of 37%. You don’t need to pull out your calculator to see that this isn’t double. And for the 2022 tax year, the 37% bracket for singles began at $539,901 while the bracket for married filers began at $647,851. So if you’re a high-earner, it pays to get hitched.
The ‘Marriage Bonus’
Couples where one partner earns considerably more than the other often get the ‘marriage bonus’, where the income that would have been taxed at a higher rate for singles is taxed at a lower rate for spouses due to the disparity.
Let’s say Spouse A works full-time and earns $50,000, but Spouse B works part-time and only earns $20,000. Had they filed as singles for 2022, then Spouse A’s marginal tax rate would have been 22%, and Spouse B’s would have been 12%. They would have paid a combined $11,005.66 in taxes.
However, as a married couple, Spouse A and Spouse B’s marginal tax rate would be only 12% for both of their incomes combined, and they would have paid only $7,988.88 in taxes. That’s a very significant difference of $3,016.78.
Our tax system certainly has its quirks and inconsistencies. But in none of the above examples I gave did earning less money result in taking home more cash after taxes.
So don’t think twice about taking that promotion.