There are 2 types of people. The ones who think of income taxes like brackets, and others who think of them like champagne towers. Since they’re called “tax brackets”, most people think their taxes are determined by finding their income bracket and multiplying by the tax rate that goes along with it. If this is how you think tax brackets work, I hate to break this news to you, but nothing about taxes will ever be that simple.
How Taxes are Actually Calculated
Tax brackets are actually more complicated and sophisticated, like champagne towers. Thinking of them like brackets makes it seem like each income range has an assigned tax rate and whichever one your income falls into dictates the amount you pay. This super simplified (and wrong) version of how tax brackets work is what causes most people (maybe you) to think that if you make $50k/year, which lands in the 22% tax bracket, you’ll pay $11k in taxes. But that’s not at all how tax brackets work.
Instead, they work more like champagne spilling down a tower. First, your income fills up the first cup, then spills into the second level of cups, then the third, and so on. The amount of income that’s poured into each level is then taxed at the rate designated for that level. This results in you paying wayyyy less in taxes than bracket thinking predicts. Here is an example for some more clarity.
If someone is making $50k/year, the first level our example person, let’s call her Thelma, will fill up is the standard deduction bucket. A standard deduction is an amount that someone who doesn’t itemize their taxes can deduct from their taxable income. It is essentially your tax-free income amount.
Thelma is single, so we will use the tax rates indicated in the single column from our table above. If you’re married and file your taxes jointly, you would use the rates in the “Married Filing Jointly” column. (There are also other tax filing types, but these two seem to be the most popular. For more tax filing options you can visit IRS.gov.)
The first cup Thelma is going to fill up is the standard deduction cup, and it gets $12,550. After filling that tax-free cup, she has $37,450 in taxable income leftover. Level 2 has the 10% tax cups and can hold up to $9,950. Thelma fills the cups on the second level and has a balance of $27,500 left to keep pouring. The third level holds up to $30,575 ($40,525-$9,950), so all of Thelma’s remaining salary will go into those cups, leaving her with an empty champagne bottle.
Here is a graphic for visual people like me.
Based on bracket thinking, Thelma would have fallen into the 22% tax bracket and paid $11k in taxes. After pouring her salary into the champagne tower, you can see that Thelma doesn’t even have enough champagne to make it to the 22% level, so she definitely won’t pay $11k in taxes.
Here is what she’ll actually pay. The standard deduction cup is tax-free, so she pays $0 in taxes for the champagne at the top level. The second level holds $9,950 and is taxed at 10%, so Thelma pays $995 in taxes for level 2 of the tower. The third level of cups didn’t quite fill to the brim and only contains $27,500 at a tax rate of 12%. Total taxes owed for level 3 are $3,300. So Thelma’s total tax bill is only $4,295! That’s a whopping $6,705 less than the total assumed using bracket thinking. So while the champagne tower method of taxation is more complicated, it also ends up being way friendlier on your wallet.
What Happens to Your Taxes When You Get a Raise
The formal term for champagne tower tax thinking is marginal tax rates, and now that you understand how they work, if you ever hear someone say they don’t want to take a raise because it will put them in the next tax bracket, please do your best not to call them an idiot while also educating them on how dumb that thought is.
Since you’ve now learned how marginal tax rates work, you know that the only money from the raise that will be taxed at a higher rate is what overflows into the next level of champagne glasses.
Let’s say our girl Thelma gets a raise (go Thelma!) and her new salary is now $60k/year. This will give her the new tax breakdown below.
So now she’ll pay $0 in taxes for level 1, $995 for level 2, $3,669 for level 3 (remember she didn’t fill the level 3 cups up before her raise), and $1,524 for level 4. Her new total tax bill will be $6,188.
While that is almost $2,000 higher than she was paying before, it is only a small portion of her $10,000 raise, and $7,200 less than the $13,200 tax bill that bracket thinking would have predicted ($60k x 22%). Even with the increased tax bill, she will still have $8k more in after-tax earnings. So the next round of champagne is on Thelma!
The idea that your tax bill is simply determined by which tax bracket you fall into, or that you’ll lose money by entering into a new tax bracket is ludicrous. Next time you get into a debate about tax policy or hear someone say they don’t want to take a raise to avoid paying higher taxes, go grab a glass of champagne with them and give them a lesson on how marginal tax rates actually work.