Explaining The Tax Brackets

One of the most common sources of confusion when it comes to taxes are the tax brackets. Today we’ll explain why people get confused, break it down in simple terms, and in the end, all of you will be experts and will be able to help your misguided friends.

The United States has a progressive tax system. That means that as you make more money, you are taxed at a higher rate. We’ll break that down further in a minute

The Confusion

Once in a while you will hear someone say, “I don’t want a raise, because it will put me in a higher tax bracket and I will end up making less.” These people don’t understand the tax brackets and should read the rest of the article to find out what really happens.

The people who say these things mistakenly think that when you enter a higher tax bracket, all of your income is taxed at the rate of your new tax bracket. That’s actually not how it works. When you do your year end tax calculations, only a portion of your income is taxed at the rate of the new tax bracket.

What Really Happens

The 2010 tax rates for Single Filers are as follows:

We see that anyone who makes up to $8,375 is in the 10% tax bracket while someone making up to $34,000 is in the 15% tax bracket.

While your friend may think that making $20,000 will stick him with $3,000 in taxes, that’s actually not the case. Instead, you are taxed at 10% for every dollar you make UP TO $8,375, and at 15% for every dollar you make between $8,375 and $34,000. So your friend making $20,000 would actually have taxes of $837 (10% of $8,375) plus $1,744 (15% of the difference between $20,000 and $8,375, or 11,625), for a total of $2,581.

That was a very basic example. One thing this doesn’t account for is the standard deduction as well as the personal exemption deductions (amounts you dont have to pay tax on). The best way to quickly find your federal tax rate is by checking out this tax calculator to find out your tax rate. It also tells you how much total taxes you pay and shows what your “real tax rate” is.

Your “real tax rate” is the percentage of total income you spend on taxes. Using the calculator, someone earning $50,000 has total taxes of $5,944, which is 11.89% of total income in taxes. That’s less than half the 25% your friend at the beginning thought he’d have to pay!

Do you have a better understanding of tax rates? So next time you hear someone considering a raise, you’ll be able to tell them that of course they should take it!

11 Responses to Explaining The Tax Brackets

  1. Another great reason to put as much of your income as possible into a tax deferred retirement account! Thanks for sharing this info.

  2. Everyday Tips says:

    This is a fantastic post. Most people do forget that their tax rate is ‘graduated’. I can’t count how many times I have heard the ‘I shouldn’t work because it won’t be worth it as we will move into a new tax bracket’ discussion. Of course, there is some effect, but not as substantial as many think.

    • Daniel says:

      @Everyday Tips, Thanks, I know lots of people are confused about this. Many just don’t know, which leads to a lot of confusion with public policy as well. Hopefully we can educate people so they know what changes to tax laws mean!

  3. Nunzio Bruno says:

    First let me say thank you! Thank you for posting this because you don’t know how many times I had to explain how tax brackets actually work to clients of mine. Great break out! And now the next time someone tries to complain to me about the horrors of their tax situation I’ll just be emailing them this little gem of an article. Now the next part of the conversation will be to see how you handle the Alternative Minimum Tax (AMT) definitely not going to be as cut and dry ;p

  4. Careful, that $20K earner has an exemption, $3650, and standard deduction, $5700.
    So the first $9350 isn’t taxed at all.
    Your example is correct if you said his “taxable income” was $20,000.

    Not to split hairs, but that $9350 represents what I call the “zero bracket” and if you do the math, it would take a next egg pre-tax of $233,750 to withdraw that $9350 each year at 4% withdrawal rate. That’s more than many will have by the time they retire.

    • Daniel says:

      @joetaxpayer, Absolutely right, I tried giving a VERY basic example. I think the more math and deductions you throw in, the more complicated it gets. And then suddenly “breaking it down” turns out to confuse people even more.

      The calculators take into account the exemptions and deductions and give a more specific picture. But for the math purposes of this example, I thought it was ok to leave it out.

  5. ira says:

    I think you explained it really well. People, of course, are mistaken to turn down a position with a raise because they think they will be making less. They will always be making more. But, if the raise comes with a lot more work, expectations, pressure, etc. then the calculation will be whether it’s worth it. So, if you’re offered a $5,000 raise, but a lot more work, you might want to consider that after taxes that $5k may be only $3,100 net (after you pay 25%, say, in federal taxes, 5% in state taxes, and 7.6% in FICA). So now, you’re making $60 extra a week. That should help you decide whether it’s a good enough deal.

  6. FinEngr says:

    Then it gets even more confusing since you can’t calculate your state income tax the same way. Hence why it’s great to live in a tax-free state.

  7. James says:

    i think this is a great post and an even better lesson on how to read a tax bracket breakdown.

    As for make money that is a good thing and should not be looked down upon.

  8. Money Smarts says:

    Great clarification of the greatly misunderstood marginal tax rates!

  9. Lauren says:

    Great post! Clears up a lot of confusion. Too often I hear that about raises.

Get Income and Money Saving Tips To Your Inbox

Get Income and Money Saving Tips To Your Inbox

Want more tips on how to make more money each month? Sign up to receive the great tips and tricks to boost your income and save more!

You have Successfully Subscribed!