Tax season is upon us, which means lots of Americans are moaning and groaning about their tax brackets. You may have heard a family member or friend complain along these lines:
"My promotion and raise put me in another tax bracket. Now I'm paying 22 percent in taxes to the government instead of 12 percent. It's outrageous!"
Two things here: if they are making more money, that's always a good thing, even with taxes. And the second thing is that a complaint like this is based on a misunderstanding of their effective tax rate and how federal income tax brackets work. Here's why:
The Internal Revenue Service (IRS) uses a progressive tax system with seven tax brackets, each assigned a rate ranging from 10 percent to 37 percent, to determine what an individual owes. These rates also have dollar ranges attached to them, which are dependent on filing statuses (single vs. head of household vs. married joint filers, etc.). The ranges change from year to year, depending on inflation.
The person in the example above is not going to have to pay 22 percent tax rate on all of their income, which would amount to $11,000 in taxes if they have $50,000 in taxable income. Instead, their taxable income will be taxed at three different rates. Only the portion of their income that exceeds the 12 percent bracket will be taxed at the 22 percent rate.
If they're a single filer in 2020, this would look like:
|Rate||Taxable Income Bracket||Taxes Owed|
|10%||$0 - $9,875||10% of taxable income or $987.50|
|12%||$9,876 - $40,125||$987.50 + 12% on the amount over $9,875 or $3,630|
|22%||$40,126 - $85,525||$4,617.50 + 22% on the amount over $40,125 or $2,172.50|
They would owe $6,790 on taxable income of $50,000, far less than the $11,000 they mistakenly believed they'd owe Uncle Sam! Only $9,875 of their income would be taxed at the 22 percent rate.
In effect, their effective tax rate is somewhere closer to 13 percent!
(See a complete list of 2020 federal tax brackets here.)
Of course it's painful when you owe tax money to the government, which is why many Americans look for legitimate ways to reduce their taxable income. (Note: The federal tax filing deadline for individuals has been extended to May 17 this year.) Keep in mind that taxable income is not your total earned income, but the amount that's left over after adjustments and deductions you take on your tax forms. You can reduce your taxable income by doing things like increasing your contribution to your retirement plan at work and/or contributing to a traditional IRA, donating to a charity, selling stocks or mutual funds at a loss from your investment portfolio to offset any capital gains, or by using other means that your accountant or financial planner suggests.
Getting a raise at work is cause for celebration, not an opportunity to fret about how much you'll be paying in taxes. Instead, spend your energy looking for ways to make that additional income work for you, such as paying down high-interest debts and building up your emergency savings, actions that will increase your total net worth. You could also sign up for automatic increases to your 401(k) retirement plan if your employer offers that feature. If you get a 3 percent raise every year, you could increase your retirement contribution by 1 percent, eventually maxing out your contributions with very little pain.
The content is developed from sources believed to be providing accurate information. The information in this material is not intended as tax or legal advice. Please consult legal or tax professionals for specific information regarding your individual situation.
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