$1 In Additional Income Does Not Mean $2,400 In Additional Taxes

Every so often, I meet with someone who has no other choice but to earn more income.

Whether that income is earned by working overtime, getting a part-time job, or working for themselves on the side, it’s needed.

Sometimes when this is recommended, I am met with resistance. They might say: “Well, I would like to earn more money but if I earn any more, I’ll be in a higher tax bracket. I cannot afford to pay those higher taxes”.

While that statement is partially true, it does not mean what some people think it does. Some believe that if their additional income bumps them into the next tax bracket, somehow their entire income is now subject to that higher rate. Fortunately, that is incorrect. 

Let’s talk about marginal tax brackets and debunk this myth!

How Marginal Tax Brackets Work

The United States Tax Code is a progressive system. In other words, as your income increases, your average tax rate will also increase. When you earn additional income, that new dollar of income may be subject to a higher tax rate than the last dollar.

In order to illustrate this system, let’s look at an example. Please keep in mind that these numbers are not actual figures in the US Tax Code. They are fictional but still similar to the 2013 tax brackets for single filers. They are rounded to make calculations and examples easier to understand. Now on to the fictional tax brackets:

• 10% on taxable income from $0 to $10,000
• 15% on taxable income from $10,001 to $30,000
• 25% on taxable income from $30,001 to $80,000
• 28% on taxable income from $80,001 to $180,000
• 33% on taxable income from $180,001 to $400,000
• 39.6% on taxable income from $400,001 and above

So, let’s suppose you had taxable income of $80,000 in Year 1 and now in Year 2 you plan on having $80,001.

The misconception starts with thinking that the $80,000 in Year 1 will be fully taxed at 25% for a total tax bill of $20,000 (25% x $80,000). If you believe this then you may also think that by earning that extra $1 in Year 2, you will now be fully taxed at 28% resulting in a total tax of $22,400 (28% x $80,001). So you say to yourself, that extra $1 that I earned cost me an additional $2,400. I lost $2,399! That statement is incorrect on both accounts.

Here is what the taxes actually look like in Year 1:

• 10% on the first $10,000 = $1,000
• 15% on the next $20,000 = $3,000
• 25% on the next $50,000 = $12,500
• = a grand total of $16,500 – NOT the $20,000 like originally thought

Here is what the taxes look like in Year 2 with the additional $1 in taxable income:

• 10% on the first $10,000 = $1,000
• 15% on the next $20,000 = $3,000
• 25% on the next $50,000 = $12,500
• 28% on the next $1 = $0.28
• = a grand total of $16,500.28 – NOT the $22,400 like originally thought

So as you can see, by earning that extra $1, you only increased your tax liability by $0.28. However, you could say that you are now in the 28% tax bracket. Impress your friends!

So get out there and earn more income!

Note: None of this information should be construed as tax advice. Please seek the assistance of a tax advisor if you have additional questions regarding your personal situation. Also note that I did not take into account other issues such as different tax rates for different types of income (dividends, capital gains, etc.) and the Alternative Minimum Tax. Deductions and credits were also not taken into account.