Tax Brackets

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Taxes are very daunting the first time you encounter them, and can be confusing even for those who deal with them all the time.

This post is meant to clear up a misunderstanding that is extremely prevalent.

That misunderstanding is about how tax brackets work. I have heard many times, from friends and clients alike, that they do not want to earn a certain amount of money because it will ‘move them into a higher tax bracket’. Usually what they mean can be illustrated in the following example:

If there were two tax brackets, one from $1-100,000, where income is taxed at 10%, and one from $100,000 and beyond taxed at 20%, they believe that if they earn $95,000, they will pay $9,500 in taxes and keep $85,500, but if they earn $105,000, they will be taxed at 20%, paying $21,000 in taxes and keeping just $84,000.

In fact, the way income taxes work, you will almost always be better off by earning an extra dollar. That’s because brackets don’t go away once you pass them. In our example-world, everyone who earns up to $100,000 pays 10% in tax, and if you earn over $100,000, you pay $10,000 in tax on the first $100,000 that you earned, and 20% on all of the other dollars. Our hypothetical $105,000 earner will pay $10,000 in tax on the $100K and $1,000 in tax on the next $5K, paying total tax of $11,000 and keeping $94K.

I should note that there are a few exceptions (two examples below, but certainly not exhaustive) to the rule of thumb that these ‘cliffs’ do not exist, a common one is the price you pay for medicare. Other exceptions that come to mind are for those receiving significant assistance (mostly near poverty lines or receiving disability benefits). In some cases increasing their income by $1,000 may reduce benefits or increase taxes on them by close to or more than that same $1,000.

Assuming no exceptions apply to you, you can relax, there are no magic earnings numbers you need to avoid because they will cost you money.

Of course, you may be less inclined to work extra for the second $100K if it is taxed twice as much. An economy-wide application of this concept is the Laffer Curve.

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