For many wealthy taxpayers, news about higher tax brackets can bring feelings of anxiety. A high tax bracket often implies that a person making a good income will pay a large amount of their income in taxes.
That's misleading for two reasons. First, a significant portion of your income is never taxed at all. Virtually everyone is eligible for some tax deductions -- even if you don't have many, you'll still get the standard deduction, which means that some of your income is never taxed at all.
The second reason is that high tax brackets only affect a portion of your income, the amount that's over that threshold. If you see an example "tax bracket" where people with incomes of more than $400,000 a year are in the 50% tax bracket, that only affects the extra money they make beyond $400,000 a year. The first $400,000 is taxed a lot less than what you might think.
When you receive your paycheck, you'll notice that your employer has kept a portion of your pay for income taxes. That portion goes to the IRS.
Filing your taxes with the IRS determines how much you owe. It's based on your income, as well as other factors such as the number of dependents you have. You can file your taxes yourself (by using tax software, and there are some free tax software packages that work for simple returns), or you can pay a tax specialist such as H&R Block to do it for you, and they even offer no-contact tax filing that respects social distancing guidelines.
The IRS uses the money already set aside by your employer to pay that tax bill, then sends you the rest in the form of a tax refund. The sooner you file before the April 18 deadline, the sooner you get that refund.
The big question, of course, is how much of your income is going to taxes. That's where tax brackets come in. They indicate the amount of federal income taxes you'll owe.
Tax brackets divide your income up into small slices. In each of those slices, you have to pay a certain percentage of that slice in income taxes. Let's look at the current tax brackets for an example.
|Bracket||Taxpayers Filing Single||Married taxpayers Filing Jointly|
|10%||Up to $9,950||Up to $19,900|
|35%||Over $209,426||Over $418,851|
Source: Internal Revenue Service
Let's say single-filer Johnny makes $120,000, but after deductions, his taxable income is $100,000. His income is then sliced up into the various tax brackets.
Overall, he pays $18,021 in income taxes or 15% of his total income. Although he's in the 24% tax bracket, he's only paying 15% of his income in taxes.
What happens to a person's taxes if they move up a tax bracket? This is often presented as a disastrous scenario, but in reality, it's not that big of a difference.
Let's say Jill files, as a single person, earns $40,000 a year, but after deductions, her taxable income is $30,000.
The first $9,950 of her taxable income goes into the 10% bracket, and thus she owes $995 on that portion of her income.
The remaining $20,050 of her income goes into the 12% bracket, and thus she owes $2,406 on that portion of her income.
She owes a total of $3,401 in income taxes, which is only 8.5% of her total income. She's in the 12% tax bracket, but only paying 8.5% of her income in taxes. She's keeping $36,599 of her $40,000 income.
Now, let's say Jill is an awesome worker and her pay gets doubled. She's now earning $80,000 a year, and $70,000 of it is taxable.
In all, she now owes a total of $11,148.50 in income taxes on her $80,000 salary, or an overall 13.9% tax rate. She's in the 22% tax bracket now, but the only thing that changed is that some of her big raise is taxed at 12% and the remaining portion is taxed at 22%. She's keeping $68,851.5 of her $80,000 salary, and pocketing $36,331 of her $40,000 raise — more than 90% of her raise stays with her, even though she went to a higher tax bracket.
Absolutely not. When you move into a higher tax bracket, all that it means is that your additional income will be taxed at a slightly higher rate than before. The rest of your income continues to be taxed at the lower rate it always has been.
You want to get every dime of income you can because the vast majority of it will stay in your pockets, even if you go into a higher tax bracket. All the higher tax bracket means is that you're now earning so much, a bit of your income is now taxed at a higher rate than before. You earn more, you keep more, regardless of what tax bracket you're in.
[This article was originally published on the Simple Dollar in December, 2020. It was updated in November, 2021.]