After “How do I avoid paying taxes?” The questions I get the most often is related to tax brackets and raises. There is a common discrepancy between how tax brackets actually work and how many people believe they work. Many people think that when your amount of your income moves into the next tax bracket all of your income is taxed in that next tax bracket. Luckily, this is not true! We will go through a short example to show the proper treatment of your income when you change tax brackets. As I usually do we will look at an individual filing Married filing Jointly.
Even though we are looking at a married tax payer I am going to include the tax brackets for all filing statuses, so you can create your own example if you want.
|Tax Rate||Individual||Married Filing Jointly||Married Filing Separately||Head of Household||Surviving Spouse|
As you can see from the chart above if you are married filing jointly and your taxable income is $19,000, you are in the 10% tax bracket. Ignoring any other taxes or credits your tax liability is $1,900. Now, let’s say you get a raise and it increases your taxable income to $20,000. Your income now puts you in the 12% tax bracket. Those who believe the tax bracket fallacy would expect your tax liability to be $2,400 which is $20,000 multiplied by 12%. This is not correct. The calculation is slightly more complicated. To calculate your tax liability, you now take $19,050 (the top of the first tax bracket) and multiply it by 10%, giving you $1,905. Then you take your $20,000 taxable income and subtract the $19,050 ($950). You then multiply the $950 and multiply it by 12% giving you $114. Finally, you add the $1,905 and $114 together to get your correct tax liability of $2,019. As you can see you have a saving of almost $400 by calculating your taxes correctly.
To drive the point home, we I will show one more example showing how you handle multiple tax brackets and give you a quick practice problem, so you can try for yourself.
In this example you are again married filing jointly, but this time your taxable income is $160,000. As you can see you fall into the 24% tax bracket. To calculate your tax liability, you multiply $19,050 (the top of the tax bracket) by 10% to get $1,905. Then you take $77,400 (again the top of the tax bracket) and subtract $19,050 to get $58,350 and multiply it by 12% giving you $7002. Now you subtract $77,400 (the top of the previous tax bracket) from $160,000 (your taxable income) to get $82,600. Then you multiply that by 22% to get $18,172. Finally, you add the three numbers you calculated together to get a tax liability of $27,079. Again, to compare this to the calculation if you follow the tax bracket fallacy you would expect to have a liability of $35,200.
For the try on your own problem lets assume again that you are married filing jointly and your taxable income is $330,000. Below I will provide the final answer.
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