How many times have you been warned to be careful about “pushing yourself into the next tax bracket” as if this might awaken the flying monkeys at the IRS to whisk you away to the wicked witch’s castle? Is it really a big deal? Sometimes it can be, but usually, it isn’t. As you might guess, it depends on how far into the next bracket you’re talking about and which brackets you’re moving into and out of.
The United States has used a progressive marginal tax bracket system since the modern income tax was introduced in 1913. Prior to that time, the only period that income tax was levied was from 1861 to 1872.
Introduced to help the Union raise funds for the Civil War, two tax brackets were used. There was a 3% tax on all income up to $10,000 and 5% on any income above that threshold. That system was repealed in 1872, giving Americans a 41-year reprieve from any income tax at all! i
In the modern U.S. federal tax system, income is taxed under the marginal brackets illustrated below (for tax year 2022):As you can see, some bracket jumps are larger than others. It’s important to remember that the only income that is applied to these brackets and taxed is the income left over after deductions are applied.
Common deductions include the standard deduction (married couples filing jointly in 2022 receive $25,900), deductible retirement account contributions, or, for those itemizing their deductions, charitable contributions and mortgage interest. What remains after subtracting these deductions from gross income is known as taxable income, and this amount is applied to the tax brackets above.
For example, if a married couple had taxable income of $75,000 in 2022, they would pay 10% on the first $20,550 of income and 12% on the next $63,000 of income. In this example, they’ve paid $8,589 on $75,000 of income or an effective tax rate of 11.45%.
Since their $75,000 of taxable income was what was left after deductions, the effective tax rate on their gross income could be quite lower than 11.45%. It’s common for the top marginal tax rate and effective tax rate to differ dramatically.
What happens if they have unexpected income? If they earned an additional $10,000 and “pushed themselves into a new tax bracket” of 22%, they simply pay the higher rate on only the amount that spills over into that next bracket. In this case, they are $1,450 past the 22% bracket, so they pay 22% on those additional dollars instead of 12%.
This does not mean that all other income is retroactively taxed at the higher rate. However, if it’s possible to spread additional income over two tax years (such as when taking large retirement account withdrawals), it may be wise to try and fill up the lower tax brackets more completely over two years than allow more income in one year to take up a large portion of a higher bracket. The goal is to keep your effective rate as low as possible.
Tip: It is virtually impossible to make less money after taxes by making more money. So, if your employer tells you it might be a good idea to work for less because you’ll take home more after taxes, find a new employer.
Important Thresholds and Your “Top Bracket”
There are thresholds that bear monitoring. For example, when you move from the 12% bracket to the 22% bracket, you will no longer be eligible for a 0% capital gains rate on profitable investment sales. This is the only tax bracket that has a unified rule elsewhere in the tax code, so not only is every dollar earned over the limit taxed at a higher rate, but a new rule on your investment sales comes into play.
It’s also worth noting that any additional income (a bonus you weren’t expecting, game show winnings, etc.) will be added to the “top” of all other income. Consider the image of the glass of water below. You can’t add water to the bottom bracket if that bracket is already full. Thus, all new income is taxed at the lowest rate that isn’t already filled up.
This logic also applies to subtractions or deductions from your income. If you make a $5,000 deductible contribution to your Health Savings Account for the year and you are in the 28% tax bracket, that $5,000 will be subtracted “from the top.” That means you’ll save $5,000 x 28% in taxes, or $1400. Even though your effective tax rate on all income may only be 14%, you always save what your top marginal tax bracket reads.
Collaborating with a knowledgeable CPA and financial planner can save you time and money during tax season. Understanding the concepts above can also help alleviate much of the stress that comes from tax bracket myths and urban legends. Consult with a tax professional before making any important financial decisions, and you won’t have to worry about those flying monkeys!
i The Purpose and History of Income Taxes | St. Louis Fed (stlouisfed.org)