Understanding Tax Brackets

By Student Ambassador Jack 

Have you ever heard that taking a raise could cost you money because it places you into a higher tax bracket? That idea is a myth, and flat out false. Something called marginal tax brackets explain why this is false.

Last week I was swiping through TikTok as teens do, and I came across a video sharing this idea. The short 15 second video explained that if you are offered a raise that would push you into a higher tax bracket based on gross income, it may make sense to refuse that raise because your tax bill would be greatly increased, in turn reducing your overall income. The only problem with this is that in the US, a taxpayer is only charged the marginal rate, or the rate of the ‘tax bracket’ on the income that falls into that bracket, think buckets. In each bucket is the amount that the Internal Revenue Service, IRS, determines for that year. The rate on each bucket, or bracket, is the marginal tax rate. The amount of overall taxes you pay as a portion of your gross income is referred to as your ‘effective tax rate’. The distinction between these two rates is very important. Here is some background info before we dig into the numbers.

• For the 2022 Tax filing year, the tax brackets are as follows:

Each bracket designates an amount of money, first $10,275, then $31,499, and so on. The amount within those brackets is taxed at the rate in the left column.

Here’s an example:

• Victoria is a 27-year-old software engineer, making $165,000 at Microsoft.
• She is offered a $10,000/year raise, making her gross income $175,000. By the logic I outlined above, this raise would cost her more money because she is now paying a rate of 32% instead of the original 24%.
• At 32%, her tax bill would be $56000, for a net income of $119,000.

Victoria refusing the raise because of the tax bill would be a poor choice. Her income would increase with the raise because only the money in each of the brackets is taxed at the rate of the bracket, not the whole income. Only the amount of money in the 32% bracket is taxed at 32%. Think back to that bucket example.

Let’s Break it Down!

The true tax bill on an income of $175,000 is only $36,232. An effective tax rate of 20.7%, nowhere near 32%

• Using marginal tax brackets, only the money in each of the ‘buckets’, or the amount within that range is taxed at that rate. So, the first $10,275 of income is taxed at 10%, then the next $31499 of income at 12%, and so on.
• Before the raise, using marginal brackets, the tax bill would be $33,436, and after the $10,000 raise, the bill would be $36,232, increasing Victoria’s net income to $138,768 from $131,564. This proves that taking the raise, would not in fact reduce her final income.

From this example, you can see how the idea of refusing a raise to avoid an increased tax bill is simply illogical. In my own life, I am moving into the workforce and beginning to file taxes, it is critical that I understand how they should be filed. The same goes for you! Misunderstanding the concept of marginal tax brackets could cause you to refuse a raise, even though it would increase your income!

Another example wherein understanding marginal tax brackets is crucial is tax hikes on the wealthy. You may have heard at some point that raising taxes on the wealthy would be beneficial. Along with this proposal comes a storm of opposition, claiming that your tax bill will go through the roof.  Spoiler alert, it won’t. Legislation that seeks to get more in taxes from the wealthy works because marginal tax brackets only tax the amount within them, not the overall amount. In the first diagram, the top bracket is taxed at a rate of 37%. At a threshold of over $530,000 per year, a tax hike at this bracket would only affect the top one percent of income earners in America, not the average individual. Although the example of Victoria is quite simplified, you can still see how the concept of marginal tax brackets are effective at taxing wealthy individuals at higher rates, while sparing lower income earners.

I always say that knowledge is power, especially when it comes to your financial situation. With this new knowledge on marginal tax brackets, I hope you can feel more confident educating others and filing your taxes next year!