How Federal Tax Rates Work – Not What You May Think

marginal tax rates Follow Me on Pinterest Have you ever heard someone say that “I’m not going to work overtime because it’d put me in a higher tax bracket and I would owe more taxes on all of my income”?

I heard this all of the time when I was working hourly jobs throughout high school and college. I have a feeling the only reason I haven’t heard it since graduating is because I’ve been working in accounting jobs.

Have you ever heard people complain that “The government taxes my bonus checks at a higher rate, even more than they take out of my regular paycheck!”? While more federal tax is withheld, you aren’t actually taxed anymore on this income.

Intrigued or confused? Read on to learn more about why these commonly believed statements are FALSE!

How Federal (Marginal) Tax Rates Work

The United States income tax is based on a marginal tax rate system. What is a marginal tax rate system?

With a marginal tax rate system there are many different income brackets and a different tax rate is applied to each different income bracket. For instance, just the other day I listed the 2013 income tax rate tables that were updated for inflation. Let’s look at an example of a marginal tax rate table for a single person.

Marginal Tax Rate Example Follow Me on Pinterest

Notice how in the table each tax rate is only for a range of income, not all income earned? This is the key to a marginal tax system. If your total income for the year increases into a new, higher tax bracket you won’t pay the new tax rate on all of your income. In fact, you’ll only pay the higher tax rate on the income that is in the new tax bracket.

Let’s go over a quick example to make sure everyone understands how a marginal tax works. Let’s say I make $150,000 of taxable income in 2013 (two words… I WISH!). How much income tax will I owe based on the above table?

First, I’d owe 10% of all of my taxable income up to $8,925 which is a tax of $892.50 on the income in this bracket.

Next, I’d owe 15% of all of my wages in between $8,925 and $36,250 which is a tax of $4,098.75 on the income in this bracket.

Continuing on, I’d owe 25% of all of my taxable income between $36,250 and $87,850 which is a tax of $12,900 on the income in this bracket.

Finally, I’d owe 28% of all of my taxable income between $87,850 and $183,250 which would be $62,150 of income and a tax of $17,402 on the income in this bracket.

The last step is to add up the income tax owed from each bracket ($892.50 + $4,098.75 + $12,900 + $17,402) for a total tax owed of $35,293.25.

In this example, if I earned $1 more in 2013 it would be taxed at 28%. However, my effective tax rate is only 23.5%. The effective tax rate is calculated by taking total tax owed divided by taxable income for the year ($35,293.25 divided by $150,000).

The “It Will Put Me In a Higher Tax Bracket On All of My Income” Fallacy

Some people don’t understand marginal tax rates. If the above statement were true and you made $8,925 you’d owe $892.50 in taxes. Now, if you made one more dollar, $8,926, this person would think they’d owe 15% on all of their income for a total of $1,338.90. Luckily, this isn’t how marginal tax rates work.

It should be clear now that working more hours or working overtime will NOT put all of your income into a higher tax bracket like in the example directly above. It may put any additional dollars you earn into a new tax bracket, but it will NOT put all of your income in the new bracket.

Yes, you will get to keep less of the extra money you earn when you file your taxes. However, isn’t paying taxes on your additional dollars at the new tax rate better than not working the extra hours and earning (and keeping) nothing? I’d say it is, assuming you would want to work the hours to get extra money anyway.

“The Government Taxes My Bonus Checks at a Higher Rate” Fallacy

Have you ever gotten a bonus, looked at your check and wondered why it has so much taken out in federal taxes? There is an easy answer for that! The IRS allows employers to withhold federal tax at a flat 25% rate on all bonus checks regardless of your filing status and exemptions that you submitted on your W-4. Check it out straight from the IRS’s mouth… or website.

So, yes, the government does withhold more federal income tax (in some circumstances) than in a normal paycheck. However, the IRS doesn’t keep this money if it isn’t warranted (if it is indeed extra withholding).

It is very possible that when you file your tax return at the end of the year you could get a refund for the money withheld above what you actually owed on your bonus check. Of course, if you didn’t have enough money withheld throughout the year the extra money that was withheld from your bonus check will instead reduce what you owe.

See, the government doesn’t tax your bonus check at a higher rate, it just withholds federal income tax at a higher rate. If you don’t owe the money you’ll get it back when you file your tax return.

So does the marginal tax rate system that the United States uses make more sense now? Do you understand why these two common statements made above normally aren’t true? If not let me know and I’ll do my best to explain further! 

photo by: Colin_K

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About Lance Cothern

Lance Cothern, a Certified Public Accountant (CPA) licensed in the Commonwealth of Virginia, is the founder of Money Manifesto. You can read more about him here or connect with him on Facebook, Twitter, Google+ or Pinterest.

Comments

  1. This is funny…I fall into the “The Government Taxes My Bonus Checks at a Higher Rate” Fallacy. Without any sort of proof, I always assumed the government taxed my bonuses at 40%.

  2. What a great post! Very informative on how marginal tax rates work. Keep up the great info!

  3. I’ve always sort of understood that, but yeah, I think it’s a common misconception that a lot of people probably believe. I know our tax preparer lists our marginal tax rate, and he also gives us our effective tax rate for the year (as well as a three-year history) to show what our overall payout is after everything is all said and done. This is actually the most informative number.

  4. Lol, dude, I know so little about this kind of stuff, that I was fricken shocked when I read this and realized that I already knew what you were talking about! Haha, I feel smart today, thanks man. :-)

  5. Thank you for this post! I know that it may be elementary for some people, but for others (such as myself), it is really helpful!

  6. Great post Lance! I try explaining this and people look at me cross-eyed by the third sentence. I really like how you explained it.

  7. That’s too funny. I always laughed when someone would tell me, “My spouse doesn’t work because we’d have less money after the higher tax bracket!” Guess what that statement meant….the spouse gets to go to work!

  8. I’m always dumbfounded at how many people don’t understand these things. Just a couple nights ago one of my coworkers (an incredibly smart engineer) made a comment about how his bonus was taxed at a higher rate. I explained to him that when he files his taxes it would be adjusted, and he looked at me really skeptically.

  9. I agree that this misconception comes up all the time!

    But is there a case for not wanting to get into a higher tax bracket because of phase-outs of deductions, for example? Or not wanting to exceed the Roth IRA contribution ceiling cap? Or are those somehow moderated like the marginal tax rates are? (I don’t have a high enough income to worry about these sorts of things so I don’t know!)

    • There are definitely phase outs for deductions and other items like you mention but it has nothing to do with the tax bracket you are in. I believe most of them are based on taxable income thresholds set independently of tax brackets.

  10. Great way to lay out the information–it’s amazing how people tend to glaze over when this is explained. I’ll send them to this post for a reference :)

  11. jay @ effumoney says:

    I agree most people do not understand how marginal and effective tax rates work, however your calculation forgets your personal exemption ($3,900) and standard deduction ($6,100 for a single person). If you make $150k the first $10k is not taxed, so your marginal tax rate will be lower since you will save 28% on the $10k which is $2,800.

    Now taxes get more complicated when you itemize so I would just modify your calculations for the standard deduction as that math is not personalized it is too hard to give a generic calculation with itemization.

    • The post would have gotten way too confusing if I used regular income. Instead, I used taxable income which is after exemptions/standard deduction/itemized deductions. Made the whole article much easier to write :)

  12. I hear people saying stuff like this all the time. They also seem to be the ones who complain about taxes a lot even though they don’t really understand what they are complaining about.

  13. Thank you for the thorough explanation – a lot of people don’t understand how this works at all.

  14. I HAVE heard people say similarly moronic things and it’s frustrating they a) believe this or b) have never taken the time to investigate it. It’s like the people that say rich people “Have to give money to charity to reduce their taxes”. That’s one of the dumbest things I’ve ever heard. Nobody is ever “Better Off” financially having given money to charity. All they’re doing is reducing their taxable income, but they’re still GIVING MONEY AWAY! How anyone (besides a cynical jealous hater) could believe the rich are somehow helping themselves when they donate is beyond me.

  15. This is great. I definitely fell into the category of people who didn’t realize this:

    “It is very possible that when you file your tax return at the end of the year you could get a refund for the money withheld above what you actually owed on your bonus check.”

    Good to know. Will have to pass this info along!

  16. AMEN! I am going to forward your article on to a few people who need this lesson, particularly the part about bonuses…

  17. That was well done. The only thing that you forgot was to shave 6.2% (Social Security) and 1.45% (Medicate) off of most of the money as well.

  18. Lorillia|Your Money Mentor says:

    The problem is, not all people know most of the letters of our tax laws. Such laws may be an advantage or disadvantage depending on who you are, what you do, and what you know about taxation. There are tax laws which are directed towards employees and there are those which are for the business people etc.. In short, to get the most advantage from our tax laws, you need to have a tax plan which will not constitute tax evasion and is perfectly legal.

  19. Interesting your way of taxing bonuses and stuff. In the UK if you get a bonus from your employer, the tax tables take care of it automatically. This is because they are cumulative through the year – different sets for weekly, monthly and (rarely) 2 or 4-weekly paid people. So most people don’t have to fill in a tax return at all because the tax paid is always correct. Only those on higher incomes or with multiple sources etc need submit a return.

    And there is a substantial 0% tax – the first £9445 is free of income tax.

    • Our tax system is very complicated so simply having our employers withhold money won’t do. We definitely have to file tax returns for all of the crazy tax situations we have in the US.

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