How do Federal Income Tax Brackets Work?

Written by Nickel - 18 Comments

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On more than one occasion, I’ve received an e-mail asking for advice on how to keep from slipping up into the next tax bracket. The motivation behind such e-mails is typically a misconception of how our progressive tax system works. What many people don’t realize is that our federal income tax brackets reflect marginal rates, not a rate that is applied to your entire income. Here’s a quick example based on current income tax rates…

For a married couple filing jointly in 2008, the 10% tax bracket covers income from $0 to $16,050. From $16,050 to $65,100 the tax rate is 15%. And from $65,100 to $131,450 the tax rate is 25%. A couple with a taxable income of $100k will be in the 25% tax bracket, but they won’t have to pay 25% in federal income taxes on the full amount. Rather, they’ll pay just 10% on the first $16,050, 15% on the next $49,050, and 25% on the last $34,900. This works out to $17,687.50, or an effective rate of just under 18%.

Of course, you should still try to minimize your taxable income as much as possible by contributing to retirement accounts, taking advantage of perks like a flexible spending account (FSA), and maximizing your income tax deductions. But, as you can see from the numbers above, you have nothing to fear from earning a bit more money and finding yourself in a higher tax bracket. Moving to a higher tax bracket will never cause you to take home less money than if your income were lower.

Published on December 4th, 2008 - 18 Comments
Filed under: Taxes
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About the author: Nickel is the founder and editor-in-chief of this site. He's a thirty-something family man who has been writing about personal finance since 2005, and guess what? He's on Twitter!

18 Responses to “How do Federal Income Tax Brackets Work?”

1
j Says:
December 4th, 2008 at 6:51 am
Wow! A wonderfully simple explanation to an awkwardly complex tax system. j
2
gm Says:
December 4th, 2008 at 10:30 am
Good explanation. I have often argued with people who claim that they don’t want to just go over a certain figure in earnings because the net tax effect is a loss in income.

But in a progressive situation like you explained that will never happen. Of course it helps to maximize pre-tax deductions too.
3
FlatGreg Says:
December 4th, 2008 at 10:44 am
Don’t forget that those rates apply to your taxable income, not your gross income. Subtract all those deductions and your effective tax rate is even lower.
4
SanDance Says:
December 4th, 2008 at 11:41 am
“Moving to a higher tax bracket will never cause you to take home less money than if your income were lower.”

Until you hit that ceiling and the Alternative Minimum Tax (AMT) kicks in. Not a problem for me yet, but know others who never considered themselves ‘rich’ and were blindsided by this expense come tax time.
5
Mr. ToughMoneyLove Says:
December 4th, 2008 at 11:44 am
I like this topic. If you want to take an interesting ride through tax history, go back and look at the marginal rates that baby boomers like me were paying in the ’70’s and ’80’s before Reagan and then Clinton lowered them. Unfortunately, they may be heading up again.
6
nickel Says:
December 4th, 2008 at 12:10 pm

SanDance: Yes and no. The AMT is a funny thing. We got hit by it last year, and will likely face it again this year. As it turns out, we really have two tax systems, and you are required by law to pay whichever one results in higher taxes. Technically, we’re all subject to the AMT, but for most people the AMT ends up being lower than you ‘normal’ progressive tax bill, so you pay that one instead of the AMT. Anyway, the AMT is another topic entirely (and I’ve written about it in the past). I will tell you this, however… We paid the AMT in 2007 but we still came out well ahead of where we were in 2006 because we made a lot more money. As much as it sucks, the AMT is the sort of thing you should aspire to, because it means you’ll be generating much more income.
7
Jim Says:
December 4th, 2008 at 6:36 pm
AMT isn’t nearly as bad as people seem to think. The only way you hit AMT is if you have certain large deductions and high income. Most people never come close to it.
ONly 3% of people paid AMT in 2005 (newest numbers I found). >90% of the people paying AMT make over $100k. The average tax bill for people paying AMT was $4350. The average tax bill for normal returns was over $10k. THe people paying AMT are paying much less effective tax (as a %) than the rest of us.

Jim
8
Tim Says:
December 4th, 2008 at 6:37 pm
@nickel: shame on you, we shouldn’t aspire to do any such thing. we’ll miss out on Obama’s tax credit then. we all know that being middle class is the american dream, so there shouldn’t be any aspiring to become wealthier. shame on you. shame on you for making more money and not giving me any of it either.
9
Tim Says:
December 4th, 2008 at 6:44 pm
@Jim, the low % people paying AMT is due to the AMT relief Act which increased qualifying income levels.
10
nickel Says:
December 4th, 2008 at 7:04 pm

Tim: We already missed out on Bush’s stimulus check, so why should this be any different? Oh, and if you got a stimulus check earlier this year, then we did give you some money.

Also, the only reason they need to patch the AMT every year is because they didn’t have the foresight to index it to inflation when they created it.
11
Tim Says:
December 4th, 2008 at 9:38 pm
@nickel: I in fact got two stimulus checks, although the IRS decided they wanted one of them back…and since i earned enough, i was actually paying myself back, not you…so you still owe me money. and there is still no reason for me to aspire to earn more since you need to redistribute your wealth to me.

yes, i know about the AMT patch. we have patches for everything now.
12
Danielle Says:
December 5th, 2008 at 12:57 pm
I had lots of fun explaining this to my younger siblings a few years back (when they were in about 4th or 5th grade). I don’t know why more people don’t talk about stuff like this with their kids. My parents sure didn’t.
13
Rick Barrett Says:
December 6th, 2008 at 12:09 pm
It is interesting how frequent this misconception comes up. Assuming you are married and both work… there is a peak in the taxes at about $204K then as you earn more money. Then your tax rate actually goes down. This is due to Social security tax. Which is 6.2% up to $102,000 this year. And not only do you pay it your employer pays another 6.2%. So if you get a raise after making the SSI limit you get to keep that 6.2% AND BECAUSE YOUR EMPLOYER DOESN’T HAVE TO MATCH IT…you may actually be able to get all or part of that money, too. So you have opportunity at least in theory to get richer…. and pay less in taxes…. when viewed as actual tax rate… So all the income above $102K is an even better deal than the low rates on what you earn up to $102K.
14
Jim Says:
December 8th, 2008 at 5:36 pm
They’ve been regularly raising the exemptions for AMT. Since they’re raising it there hasn’t been a problem. They should just pass a law to build an automatic increase in the exemption so that it will be fixed long term. From 2005 to 2008 they raised the exemption over 5% a year which is better than peoples rate of pay has gone up.

Most of the fear about AMT is what might happen *if* they didn’t raise the exemption.

Jim
15
walt reyer Says:
June 2nd, 2009 at 7:10 am
I’m going to retire in Dec 2009. I will recieve severance
pay which will put me in the 33% tax bracket by $23,000. Would it make sense to work until Jan 1st and recieve the severance

My wife and I file jointly. She makes $25,000, I make $131,000 would we be better off to file seperatly?

Thanks!
16
Jason Says:
July 10th, 2009 at 2:48 pm
Just received a raise that puts me in the next bracket. This simple explanation was great and put me at ease! Thanks!
17
don goddard Says:
August 8th, 2009 at 12:44 pm
what is rhe standard deduction for born before jan. 2,1944 for the tax year 2009.last year it was 6,500.
18
Linda Says:
December 7th, 2009 at 5:11 pm
Do you use adjusted income or gross income when determining your tax bracket?

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