“I don’t want to make an extra $2,000 because that will put me into the next tax bracket and cost me more.”
We hear this same refrain every year around tax time. It seems just as many people believe this tax bracket myth as do people who believe in the Loch Ness Monster (which is an absurd belief, unlike believing in Bigfoot.)
The story goes that if a married couple makes $79,000, they are in the 12% tax bracket, but if they make $81,000, they will be taxed at 22%. By that logic they either pay:
- 12% of $79,000 = $9,480 ($69,520 in Net Income) OR
- 22% of $81,000= $17,820 ($63,180 in Net Income)
In this scenario, it obviously does not seem worth increasing their income if their net income will be less. However, this story reflects a common myth about how tax brackets work (much like the myth that my wife tells me that there are easy tricks to fold a fitted sheet).
A better way to understand tax brackets is to think of them as a tiered system. This means you only pay the increased percentage on the money you earn over each tier.
Let’s take our family earning $81k for example:
- On the first $19,750 they earn, they’ll pay 10% in taxes[$1,975]
- On the next amount up to $80,250, they’ll pay 14% [ (80,250-19,750) * 12% = $7,260]
- Then, they’ll pay 22% on only the amount over $80,250 [ (81,000-80,250) * 22$ = $165]
- So in total they are paying $9,400 in taxes [$1,975 + $7,260 + $165]
This is a far cry better than the $17.8k they would owe if they paid 22% on all of their income! Curious what your tax bracket is? You can see all of the 2020 tax brackets from the IRS in the table below.
So, whether you have the chance for a raise or a side hustle, the opportunity to grow your income will always benefit your bottom line in the end, even if it changes your tax bracket.