One of the most confusing areas surrounding taxes is understanding how tax brackets work and realizing where you fall within them.
I’ve had people tell me that they were going to quit jobs because they were bumped to a higher tax bracket. I personally thought for a long time that a raise (which bumped me into a higher tax bracket) was a bad idea.
We even hear of some people that want to keep mortgage payments and student loans so they can deduct the interest from those payments (because that may bump you into a lower tax bracket).
So, What Happens When You Move to a Higher Tax Bracket?
Very little in reality.
The biggest tax misunderstanding is the belief that your ENTIRE income will get taxed at the new/higher tax bracket.
Thankfully (for everybody) that isn’t how it works. What really happens is the portion of income that now falls into the higher bracket is the ONLY portion that gets taxed at the higher rate.
The remainder of your income (or what you were making before) will still get taxed at the lower bracket percentages.
For starters there are two separate tax brackets that most people should be concerned with: (1) “SINGLE” filers and (2) “MARRIED FILING JOINTLY.”
There is “married filing separately” and “head of household” as well, but I won’t show those in this post as they’re less common. The same principles apply though. As always, you should seek a competent professional to give you advice on your specific situation.
To make things simple, I just want you to view “brackets” as steps (explanation below). Here are the 2011 steps/brackets for “SINGLE” and “MARRIED FILING JOINTLY” filers:
The first thing to understand is that this isn’t the only tax you pay. The charts above show the FEDERAL tax rates. Most of you will have State taxes, Social Security, as well as Medicaid taxes in addition to Federal taxes.
The second thing to realize when looking at these “brackets” is that they don’t include deductions (there is a “standard” deduction if you cannot itemize). So, if you’re a “SINGLE” filer and you made $36,000 in 2011, that doesn’t automatically mean you’ll get taxed at the 25% bracket. What bracket you fall in, and what you end up paying in Federal Taxes, is based on the income amount NET of (or after) deductions. Topic in an upcoming post.
Start to think of each “bracket” as a step up a ladder. As a “single” filer, once you’ve passed the $8,500 income step, you then move onto the next one. Once you move onto the 2nd step, your ENTIRE income isn’t taxed at 15%, only the portion above $8,500 is taxed at the new “step’s” percentage. What was left on that first step, stays on the first step (it doesn’t move with you as you go higher up the ladder).
You will pay $850 in taxes (10%) on $8,500 of your income, and then 15% on the remainder (up to $34,500).
While you non-math nerds are probably dizzy from all of these numbers, I’d encourage you to try and understand this introductory step to taxes.
Finally, let’s look at the numbers to dispell the common notion that your ENTIRE income gets taxed at the higher rate:
Common Misunderstanding: Assuming you make $34,500 (single filer) and are in the 15% tax bracket, you DO NOT pay $5,175 in federal taxes (.15 x $34,500 = $5,175).
Reality: You pay $850 (10% on the first $8,500) PLUS $3,899.85 (15% of $25,999) for a total of $4,749.85
Now you know (hopefully) the first step to understanding taxes and tax brackets.
If you’re still confused, don’t worry. There is a reason people go to school to learn how to file taxes for you. I’ve never used a CPA myself (although I may eventually), but I have filed my taxes through TurboTax for the past 4 years.
They won’t quiz you on all of this stuff…I promise.
The articles are written by personal finance enthusiasts (not certified professionals) based on their personal experience. What works for them may or may not work for you, and you should always consult a financial advisor before making important financial decisions.
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