Some people worry that if they make more money which puts them in a higher tax bracket, then their overall income will decrease, and if you don’t have a good understanding of how the federal tax system works in the United States, this sounds reasonable.
Here are the 2020 federal tax brackets for single filers and as you can see, income under $40,125 is taxed at a rate of 12% while income over $40,125 is taxed at a much higher rate of 22%.
- 12% for incomes over $9,875
- 22% for incomes over $40,125
- 24% for incomes over $85,525
- 32% for incomes over $163,300
- 35% for incomes over $207,350
In theory, this would mean that someone who earns $40,125 per year will pay $4,815 in federal income taxes and take home $37,310 while someone who earns $1 more will pay $8,827 in taxes and only take home $31,298.
Luckily this is not how the tax system works in the United States. Fortunately for us, the US uses marginal tax rates.
What Are Marginal Tax Rates?
Marginal tax rates refer to the amount of additional tax you pay for every additional dollar earned as income.
Using our example, if you earn $40,125 per year, the first $9,875 is taxed at a rate of 10% and everything after that up to and including $40,125 is taxed at a rate of 12% for a total tax bill of $4,617.50.
Now someone who earns one dollar more will pay the same amount on the first $40,125 and then the next dollar will be taxed at a rate of 22% instead of 12%, so their total tax bill would be $4,617.72 or just $0.22 higher.
What this basically means is that getting bumped up into a higher tax bracket will not incur a huge tax burden no matter which tax bracket we’re talking about.
Instead of seeing your tax burden drastically increase when your income breaks into the next tax bracket as you can see here by the red line, there’s a nice smooth transition as indicated by the blue line from one tax bracket to the next and if you look closely enough, you’ll see a bit of an upward curve to the blue line which is an indicator the progressive (or continuous) tax brackets.
I get it, it’s a bit confusing, and it actually tripped me up for a while, but just remember that when someone says they are in the 24% tax bracket, that doesn’t mean that they actually pay 24% of their income in federal taxes.
Instead, it’s more like they pay 10% tax on their first $9,800 in earnings, everything after than up to $40,000 is taxed at 12%, everything after that up to $85,000 is taxed at 22%, and then only the income earned after $85,525 is taxed at 24%