About raises turning them into paupers is this: it will not. If someone told you they declined to accept more salary based on “higher tax brackets”, then they were simply misinformed – misguided but also likely to have a lot of misplaced confidence as well.
Here is an example of someone turning down a promotion to a higher income because they thought they would lose money when they crossed into a higher tax bracket. How absurd is that? Yet, it happens much more often than you can imagine.
Tax brackets do not create “trap doors”. Rather, tax brackets are stair steps. You do not jump from the ground to the top of the stairs, nor do you pay “to” each and every step up the stairs.
Now let us go back to what should have been at the beginning of this. Tax brackets are merely levels of taxation on income. Each level of income is taxed at a different tax rate. Only the money that falls within a specific tax bracket is subject to the corresponding tax rate of that tax bracket. That’s all. No questionable tactics nor the punishment of succeeding.
To illustrate, let us assume for illustration purposes that we live in a world that only has three tax brackets – one for lower income, one for medium income and one for high income.
- The first $7,500 of income would be taxed at a low rate.
- The next $10,000 would be taxed at a slightly higher rate.
- Anything over that will be taxed at an even higher rate.
The most common misconception? Combining your various tax rates (they don’t replace one another).
For instance, someone who has achieved a good middle class salary might think when they cross the tax threshold, all their income will fall into the higher bracket tax rate. This thought process is likely to be millions of dollars over their lifetime.
Let’s elaborate on some easy math, not difficult math, to illustrate this point: if a person earns a modest salary and remains in the lowest tax bracket, they would have to simply calculate their tax on that amount and keep the rest.
The examples become much more complex, though, when an individual starts to earn money above what is considered the lowest bracket. However, this does not mean that all the money earned in the middle income range is taxed at a higher rate; only the money that exceeded what is considered the lower tax bracket is taxed at a higher rate. All of the previous earnings retain their lower tax bracket rating. Therefore, someone who has recently crossed into the next bracket will not suffer retroactive penalties due to their increased success.
Now let’s consider the individual who earns above the median income. When an individual achieves a high income, only a small portion of their total income will be taxed as highest bracket income. The remaining portion will still be taxed at lower rates; therefore, the reason for so much fear of being placed in the highest tax bracket is way overstated.
Your effective tax rate (ETR) is the overall average you are actually paying in taxes compared to the amount of all your income. In most cases, this will be much lower than your highest bracket rate, and in many cases, it can be significantly lower.
A good metaphor is ordering food; just because you ordered one expensive item from the menu does not mean that everything else you ordered all of a sudden is going to cost the same amount, rather, how much you’re ultimately spending will tell the entire story.
So, backtracking a bit: why does understanding the effective tax rate matter so much? Because making decisions based on fear around taxes can negatively affect long-term income potential. For example, if someone passes on a promotion or avoids working overtime due to an incorrect understanding of the ETR, those choices can, over time, add up to a significant loss of potential income.
As a person’s pay goes up, the effective tax rate will not raise nearly as fast as the income. Thus, tax rates increase very slowly over time. It wasn’t until the very top pay levels that the average tax rate a person pays will even begin to reflect the highest tax bracket.
So if a person were to ever say that they would not want to earn any additional income because of the tax implications, you should recognize that context is missing from that statement.
Let me close this out where we should have started. Tax brackets are not cliffs, they are steps. A person does not “fall off” of a tax bracket; instead, it is a step that a person “climbs” to get to the next higher level (many times receiving a tax refund). When you take an additional step up (by earning more money), you are now standing 1 step higher than where you were previously.
This one concept may be able to help you avoid making expensive and costly financial mistakes.
