Who Fears a Big Bad Tax Bracket?

How many times have you heard someone say “Oh no, that will put me in a  higher tax bracket?”

Most of the time these folks do not understand how tax brackets work. A lot of folks, including some very intelligent and/or successful professional types,  erroneously believe that if their income nudges them over into the next-higher tax bracket by even $1.00, that this somehow means that the entire amount they owe in taxes goes up to that percentage on everything they earn. Moving into a higher tax bracket is usually not a big deal although many folks talk about it as if it is a tax disaster.

Bracketology

A tax bracket is a range of incomes taxed at a specific rate. Tax brackets are components of a progressive income tax system, in which taxes increase progressively as income increases. The idea is that high-income taxpayers can shoulder the burden of a high tax rate. Low-income taxpayers pay less. Here are the 2013 tax bracket tops and rates for a married couple filing  jointly:

Bracket top/ Rate $17,850 / 10% $72,500 / 15% $146,400 / 25% $223,050 / 28% $450,000 / 35% over $450,001 / 39.6%

Illusion

So, let’s suppose a husband and wife, who are folks like I mentioned above who fear a higher tax bracket, together have an income of $72,500 last year,  but this year they have a combined $72,600 of income, that is, $100 more. Let’s assume the 2012 and 2013  brackets are the same. They probably think that they paid 15% in taxes  last year ($72,500 x 15% = $10,875). These folks think that this year because they made $100 more (pushing them into the 25% tax bracket) that they’re going to owe 25% on everything ($72,600 x 25% = $18,150).

Illustration

They are wrong on both counts. They are wrong about what they owed last year and what they will owe this year.

Last year, they owed: 10% on the first $17,850 = $1,785 15% on the next $54,650 = $8,198 for a total tax of $9,983 instead of the $10,875 they thought.

This year, they’ll owe: 10% on the first $17,850 = $1,785 15% on the next $54,650 = $8,198 25% on the next $100 = $25

This yields a total tax of $10,008. Entering the next bracket cost them only  $25, not the $7,275 increase they feared. The Moral of the Story: Don’t be so afraid of being in a higher tax bracket. Don’t forego income in order to stay in a lower marginal bracket – that makes no sense. It may make sense to spread income over several years, but you are never farther ahead by having less income.

Marginal Rate
The top bracket that applies to your income is called the marginal rate. The marginal tax rate – is the rate of tax paid on an additional dollar of income. The marginal tax rate for an individual will increase as income rises and higher brackets are passed into. In the above example, if the couple made $150,000 and then they had another $1 of income, it will be taxed at 28%. Their marginal rate is 28%.

The average tax rate is the rate at which a taxpayer would be taxed if taxing was done at a constant rate, instead of progressively. It is calculated by dividing the total tax paid by income.

For our couple above, with $72,600 in income and a tax of $10,008, the average rate is $10,008 divided by $72,600 which gives an average tax rate of 13.79%. Their marginal rate is 25%, but their average rate is 13.79% –  sounds a lot better doesn’t it?

Denominator Olympics
While this example is clear, it is not at all clear what number should  be used here as “income.” Our examples used taxable income, which is the adjusted gross income minus the standard or itemized deduction minus the personal exemptions It is not the adjusted gross income. That would make your effective tax rate even lower. It is definitely not adjusted gross income plus tax-exempt interest, non-taxable social security, and other non-taxable items which would drive the average tax rate even further down.

The last denominator is the number the taxing authorities would like to use to impress you with how little tax you’re paying. When commentators and politicians throw average tax rates around, it is impossible to know if they are comparing apples to oranges because the calculation of the average rate is not made consistently.

Beware.