Introductions are great, but let’s skip the foreplay and get straight to the point.
Most Americans don’t understand taxes.
In fact, two-thirds of us can’t pass a basic financial literacy test.[1] Indeed, many factors contribute to our mindlessness around money, but for today’s conversation, let’s home in on those pesky payments to Uncle Sam.
I recently read a Reddit post where one user was explaining how his coworker, let’s call him Bob, turned down a $2,000 bonus so he wouldn’t be “pushed into a higher tax bracket.”
There is only one problem…that’s not how the U.S. federal tax system works.
If you were the type of person who read Spark Notes in high school, let me save you some time. Keep your bonus! But for those looking to learn, let’s dive into why this was such an erroneous error.
The Mistake We Make
Many people, including Bob, make the mistake of thinking that 100% of their income is taxed at their highest marginal bracket. This is not true. However, assuming that was the case, the logic is as follows.
For an individual making $39,000, their highest marginal tax rate is 12 percent (see the table below). If 100% of their income is taxed at this rate, they will pay $4,680 in taxes, excluding any itemized or standard deductions. Their after-tax income would be $34,320.
Suppose then this individual is offered a $2,000 bonus from their employer. Assuming they accept the bonus, it would increase their gross income to $41,000, therefore pushing them into the 22 percent tax bracket.
If all their income is taxed at 22 percent, their tax bill would increase from $4,680 to $9,020, resulting in an after-tax income of $31,980.
These miscalculations make it appear that even though someone increases their gross income, by being “pushed” into a higher bracket, they decrease their after-tax income.
Given the choice, any red-blooded American would take $34,320 over $31,980.
Fortunately, making more money doesn’t have to cost you.
How It Really Works
The income earned in each bracket is taxed only at that corresponding marginal rate.
In Bob’s case, the $2,000 bonus would, in fact, have “pushed” him into a higher tax bracket. However, only $1,525 of that bonus (the amount in excess of $39,475) would have been taxed at 22 percent. The rest of his income would have remained in the lower tax brackets.
See Bob’s tax table below.
Now that we have a better understanding of marginal tax brackets, let’s correct our miscalculations from earlier.
Taking the above into consideration, Bob gave up $1,607.50 in after-tax income by turning down his bonus.
Bob is sad ☹
Moral of the Story
It is a myth that being “pushed into a higher tax bracket” means you will have less after-tax income. The truth is you only pay a higher tax rate on the portion of your income that falls within that next bracket. Thank goodness! Can you imagine a world where earning more on paper meant you have less in your paycheck? Thankfully, that is not the case.
So what is the moral of the story?
Keep your bonus and make that money!
Stay Savvy, my friends.
Disclosure: Guardian, its subsidiaries, agents, and employees do not provide tax, legal, or accounting advice. Consult your tax, legal, or accounting professional regarding your individual situation.
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[1] FINRA, 2016 - Financial Capability in the United States 2016
[2] Internal Revenue Service, 2019 - 26 CFR 601.602: Tax forms and instructions.
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Registered Representative and Financial Advisor of Park Avenue Securities LLC (PAS). Securities products and advisory services offered through PAS, member FINRA, SIPC. Financial Representative of The Guardian Life Insurance Company of America® (Guardian), New York, NY. PAS is an indirect, wholly-owned subsidiary of Guardian. Lifetime Financial Growth is not an affiliate or subsidiary of PAS or Guardian. Guardian, its subsidiaries, agents, and employees do not provide tax, legal, or accounting advice. Consult your tax, legal, or accounting professional regarding your individual situation. Links to external sites are provided for your convenience in locating related information and services. Guardian, its subsidiaries, agents, and employees expressly disclaim any responsibility for and do not maintain, control, recommend, or endorse third-party sites, organizations, products, or services, and make no representation as to the completeness, suitability, or quality thereof. CA Insurance License # 0M64579
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