02/21/15 – Don’t be that schmuck that doesn’t understand how taxes work

Have you ever heard someone complain about a raise pushing them into the “next tax bracket”? Or even *gasp* saying they won’t ask or turned down a raise because it would? Did you nod your head in agreement or did you smack whatever friend that was complaining and teach them a thing or two about how taxes work? Surprisingly, about 50% of people don’t understand how marginal tax brackets work… No matter what, if you get a raise, it will be just that… a raise. Doesn’t matter if you go from 10% -> 39.6% tax bracket and get a raise of a single dollar, you will still end up with more money…

The math is simple and the keyword is “marginal”. When you “move up” tax brackets, the new tax rate does NOT apply to your entire income. It only applies to the income over the amount at the bracket cutoff. For example, one threshold is going from $47,750 to $47,751, with taxable income of $37,450 vs $37,451, moving you from the 10% to the 25% marginal tax bracket over a single dollar. Sounds terrible, huh? Wrong! The 25% only applies to that dollar you made over $47,750. So, your raise, although not as big as it used to be when you made less, is still 75 cents for every dollar more you’ll be making. Your tax bill will be exactly 25 cents more than the guy making 1 dollar less than you, but that’s just fine, you netted 75 cents more than he did.

Here’s a nice graph illustrating the misconception:

income vs taxes

Notice the “big jumps” in the misconception line, that’s why people have been misled to think moving up tax brackets leads to substantially more taxes. With that said, when taking into account some welfare programs, things do get into a grey area with certain income thresholds at the lower end, but this doesn’t have anything to do with your tax bill. The reality is, there is no big jump in taxes when you “move up” tax brackets… So don’t be that guy that nods your head in agreement anymore… tell your friend that if she splits the raise with you, you’ll gladly pay the difference in her tax bill.

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