This post isn’t about saving money as much as it’s about understanding it. Just about any time taxes have come up in conversation, I’ve found myself explaining to my peers what the graduated income tax actually does. Luckily, it’s not that complicated.
Have you ever heard someone say it’s not worth it to work more because your tax rate will go up and you’ll end up making less money? It’s a common belief, but it’s completely wrong. Your tax rate will never go up in such a way that it causes you to lose money as a result of earning more.
If you’re single, your federal income tax schedule is as follows (in 2015):
10% $0 – $9,225
15% $9,225 – $37,450
25% $37,450 – $90,750
28% $90,750 – $189,300
The rates go up gradually and top out at 39.6% for anyone earning over $413,200 annually, but I sincerely doubt any of my readers have that much money, so I’m going to ignore it.
If you earn $50,000 per year, solidly in the 25% bracket, you may think that means you pay $12,500 per year in federal taxes. You would be incorrect.
See, the marginal tax rate is only the rate you pay on the amount that is above the last tax bracket. So, if you make $50,000 you actually pay:
10% of $9,225 = $922.50
15% of $28,225 ($37,450-$9,225) = $4,233.75
25% of $12,550 ($50,000-$37,450) = $3,137.50
TOTAL = $8,293.75, for an effective tax rate of 16.6% ($8,293.75/$50,000)
If you make $38,000 per year, you only pay the 25% tax rate on the $550 that pushes you into that bracket, not on your entire paycheck.
Importantly, your taxes are not calculated on your gross income. Any pre-tax deductions, like for a 401(k) or Health Savings Account, come off the top first. So, if you earn $40,000 and put 10% into your 401(k), your taxable income is only $36,000. This is one of the reasons that pre-tax retirement savings are such a good deal.
The tax code gets much more convoluted for things like self-employment and capital gains, but for the typical worker, it’s pretty simple. Take a look at your most recent paycheck and make sure you understand all of your deductions.