Over the past four months, between year-end tax planning and tax return preparation, I have probably heard at least ten to twenty people talk about how if they earn any more income, then they will be in a higher tax bracket, or if they can push some income into a future year, then they will be in a lower tax bracket, as if either scenario had a drastic effect on the taxes to be paid. I want to help prevent all of you from making such statements in the wrong context (including you, Christy). Let’s start with the understanding that you, me, the bum on the corner and Bill Gates all pay the same tax rate on the first $20,000 of taxable income….and on the next $50,000 of taxable income….and on the next $400,000 of taxable income. Being in a higher tax bracket than someone else does not change the tax rate you paid on those lower amounts of taxable income.
Here is an example. Let’s compare Dr. Joe to the bum on the corner and Bill Gates, assuming that they are all married filing jointly, Dr. Joe has $300,000 of taxable income, the bum on the corner has $15,000 of taxable income, and Bill Gates has $100,000,000 of taxable income. Joe, Bum and Bill will all be subject to a 10% tax rate on that first $15,000 (not factoring deductions and tax credits). Joe and Bill will then be subject to a 15% rate on their taxable income from $18,550 through $75,300, a 25% rate on their taxable income from $75,300 through $151,900, and so on. Joe and Bill pay the exact same amount of tax on their first $300,000 of taxable income, just like Joe, Bum and Bill pay the exact same amount of tax on their first $15,000 of taxable income. Joe caps out at the 33% tax bracket, whereas Bill will pay tax at the 35% rate for a very short period of time before being in the 39.6% bracket for all taxable income over $466,950. To be clear, just because Bill Gates has $100,000,000 of hypothetical taxable income and is in the 39.6% bracket does not mean that he owes $39,600,000 of taxes (again, not factoring deductions and credits). Rather, Bill’s tax bill would be $39,545,666.
Now for the caveat. At various income levels, certain deductions start to phase out. A few examples are that the child tax credit phase out begins at $110,000 of income, the student loan interest deduction starts to phase out at $130,000 of income, and personal exemptions start to phase out at $310,000 of income. Those phase outs do not change your tax bracket, but they do increase your effective tax rate.
Now that you understand how tax brackets work, don’t be afraid to get in a higher one, and don’t try to mess around with your income thinking that if you can just barely slip into a lower tax bracket, then you will save a significant amount of taxes on all of your income.