Nobody likes paying taxes, and only a few people fully understand all the nuances of the U.S. income tax system. As another tax season approaches, American taxpayers will have to deal with major new tax provisions under tax reform, and there'll be plenty of confusion about exactly what impact the changes will have on the size of tax bills and refunds.
Yet there's something that's been in the income tax system nearly since its beginning a century ago that many taxpayers still get confused about. It's common to refer to being in a particular tax bracket or paying a certain marginal tax rate, but many completely misunderstand the implications on your overall tax bill that these concepts have. Here's an attempt to explain in simple terms what tax brackets mean -- and why proposals that refer to changing tax brackets often don't have the effect that they might appear to have.
The basics of tax brackets
The U.S. income tax system is a progressive one, which means that low-income taxpayers pay lower rates of tax than high-income taxpayers. The way this is done is by charging certain tax rates for ranges of income, referred to as brackets. For instance, under current law, taxpayers pay 10% in income tax on a certain amount of income, and then above that, a higher 12% tax rate applies up to a second threshold. This continues upward through a total of seven brackets, eventually maxing out at 37%.
Tax brackets get their names from the tax rate that applies to that bracket. Therefore, low-income taxpayers typically are in the 10% or 12% brackets, while top-income earners are in the 37% bracket. Another way of saying the same thing is that if you're in the 12% bracket, then your marginal tax rate is 12%. This means that for the last dollar of income you earned, you paid a tax rate of 12%.
The confusing thing about brackets
The tricky part is that just because you're in a given tax bracket doesn't mean that all of your income gets taxed at that rate. That's a common misunderstanding, because people get afraid when their income approaches the top of a tax bracket. For instance, the biggest jump under current tax law happens between the 12% bracket and the 22% bracket. Some mistakenly believe that if you earn a single additional dollar that takes you up to the 22% bracket, it'll cost you an extra 10 percentage points in taxes on every penny of your income.
However, that's not the way tax brackets work. The reason it's called a marginal tax rate is that the rate applies only on the margin -- that is, to the top dollar of earnings you make. All of the lower tax brackets along the way remain in effect, and you'll still benefit from the lower taxes on that income.
An example of how tax brackets work
To see how this works, let's look at a typical single taxpayer in 2018. Say that you had taxable income of $38,000 last year. When you look at the 2018 tax brackets, you'll see that with that income, you'd be in the 12% tax bracket. Your total tax would amount to $4,369.50.
Now consider what happens if what many people fear actually happens: a person gets some extra income that pushes them into a higher tax bracket. Taking the above example, assume you got a $2,000 year-end bonus. That would bring the total taxable income to $40,000, putting you in the 22% bracket.
Some fear that this leads to an automatic $4,000 bump in taxes, because the 22% bracket is 10 percentage points higher than the 12% bracket. But when you run the numbers, you'll find that the total taxes due come in at $4,739.50 -- just $370 more than the previous example.
Why the difference? The reason is that only a tiny portion of your overall income got taxed at the 22% marginal rate -- specifically the $1,300 that you earned above the $38,700 top level of the 12% bracket. The rest continued to enjoy the lower 10% and 12% tax rates.
Taxes don't have to be hard to understand
Misunderstandings like these can lead to major controversy. The recent proposal from Rep. Alexandria Ocasio-Cortez (D-N.Y.) is a great example, as many mistook the proposal to add a 70% tax bracket for income levels above $10 million as having an impact on taxpayers of all income levels.
The most important lesson you can learn about tax brackets is that the threat of a higher tax rate shouldn't keep you from earning additional income. By working through the math involved, you can figure out exactly how much extra tax you'll pay, and that'll show you that tax brackets are a lot less sinister than they seem to be at first glance.