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You got a raise! Should you worry about being pushed into a higher tax bracket?
Federal marginal tax rates mean you pay higher tax rates as your income rises, and getting a raise could mean a portion of your income is taxed at a higher rate. Getting a raise doesn't change the rate at which all your income is taxed, however, and you'll ultimately still come out ahead in the end. Here's how getting a raise might affect your tax bill.
How Tax Brackets Work
Tax brackets apply different tax rates to different tiers of your income. Taxpayers pay lower tax rates on lower incomes and higher tax rates as their incomes increase.
If you get a raise, you'll pay tax on the additional income, resulting in more tax dollars. And, depending on your new annual earnings, a portion of your income may be subject to a higher tax rate as well. This causes some to assume they'll be worse off than before if a raise pushes their income into a new bracket, but that's not how the U.S. tax system is structured.
In practice, it works like this: If you're single and make $80,000 a year, the first $10,275 of your income is taxed at 10%. The next block of income, up to $41,775, is taxed at 12%. The portion of your $80,000 income above $41,775 is taxed at 22%.
Running the numbers, your tax bill would look something like this:
10% of $10,275 = $1,275
12% of $31,500 = $3,780
22% of $38,225 = $8,410
To see how these brackets play out for the 2022 tax year, see the table below.
|2022 Federal Tax Brackets by Taxable Income|
|Tax Rate||Unmarried||Head of Household||Married Filing Separately||Married Filing Jointly|
|10%||$0 - $10,275||$0 - $14,650||$0 - $10,275||$0 - $20,550|
|12%||$10,276 - $41,775||$14,651 - $55,900||$10,276 - $41,775||$20,551 - $83,550|
|22%||$41,776 - $89,075||$55,901 - $89,050||$41,776 - $89,075||$83,551 - $178,150|
|24%||$89,076 - $170,050||$89,051 - $170,050||$89,076 - $170,050||$178,151 - $340,100|
|32%||$170,051 - $215,950||$170,051 - $215,950||$170,051 - $215,950||$340,101 - $431,900|
|35%||$215,951 - $539,900||$215,951 - $539,900||$215,951 - $323,925||$431,901 - $647,850|
|37%||$539,901 or more||$539,901 or more||$323,926 or more||$647,851 or more|
What Happens if You Move Into a Higher Tax Bracket?
Here's where the confusion often begins. Using our example above, suppose you get a $30,000 raise. Now your income is $110,000, which nudges the top portion of your income into the 24% tax bracket.
Since moving into a higher tax bracket doesn't mean all of your income will be taxed at the higher rate, your tax bill will not be $26,400, or 24% of $110,000. It's going to look more like this:
10% of $10,275 = $1,275
12% of $31,500 = $3,780
22% of $47,300 = $10,406
24% of $20,924 = $5,022
People may complain about moving into a higher tax bracket, but the change is incremental compared to your raise (for this example, your tax bill rose by $7,018, but you got a $30,000 raise). The new, higher tax rate only applies to income that is over the limit of your old tax bracket. Going forward, if you receive a bonus or another raise, you will pay the higher tax rate. Then again, you'll be receiving more income, so you'll have more money in the bank when all is said and done.
Your new 24% tax rate also does not result in a retroactive tax bill. As long as you were withholding enough money to cover your taxes before the raise, you should not owe additional taxes on the money you've already earned.
Deductions and Credits Reduce Your Tax Bill
To keep our earlier example simple, we left out the concept of taxable income. Taxable income is your gross salary minus deductions and credits. In real life, nearly everyone uses deductions and credits to adjust their tax liability. For example, most taxpayers take the standard deduction on their tax returns. As a single taxpayer earning $110,000 per year, you could take a standard deduction of $12,950 in 2022. This would reduce your taxable income to $97,050.
Tax brackets apply to your taxable income, not your gross salary. Any measure you take to lower your taxable income through deductions could potentially lower your tax bracket as well. Deductions include contributing to a 401(k) plan, traditional IRA, flexible spending account or health savings account, or reducing business income by deducting qualifying business expenses. If deductions lower your taxable income beyond the threshold for your current tax bracket, you'll have successfully dropped yourself back into a lower tax bracket.
Tax credits, such as 2021's Expanded Child Tax Credit, lower your tax bill dollar for dollar, but typically don't affect your taxable income or your tax bracket.
Should You Try to Keep Your Tax Bracket Low?
A lower tax bracket generally means a lower tax bill, but is trying to lower your tax bracket always the best thing for your financial health?
Let's go back to our original example. Your $97,050 in taxable income has tipped you into the 24% tax bracket. You would rather stay in the 22% tax bracket, but to do so, you'll need to "lose" $7,975 in income. You decide to add $7,975 to your annual 401(k) contribution to drop your taxable income back into the 22% tax bracket.
Here's how this decision could impact your finances:
- You will not pay taxes on the $7,975 you contributed to the 401(k) this year. This saves you 24% of $7,975—or $1,914—in taxes. Remember that you will pay taxes on this money when you withdraw it in retirement, but that's a math problem for another day.
- The taxes you would have owed on the $7,975 if you had simply kept the money and paid taxes on it at the 24% tax bracket would have been just $160 more than what you would have paid if this money were taxed at 22%.
If staying in a lower tax bracket motivates you to make a good financial choice, there's no harm in it. But if the $7,975 you put into your 401(k) channeled money away from your monthly budget or other financial goals like saving for a down payment or paying off student loan debt, you need to weigh the pros and cons. Staying in a lower tax bracket shouldn't be your only consideration when making money decisions.
More Money Is a Plus
Moving into a higher tax bracket is more good news than bad. Though nobody likes paying a higher tax rate, everyone likes making more money. If you've recently earned a raise—or a new job with a higher salary—enjoy! You're moving up the income scale. That's a net gain, with or without higher taxes.
If you receive a raise, you may want to use the additional income to pay down your debt, build up your emergency fund or save for a long-term financial goal such as a down payment on a house. As you continue to manage your finances, be sure to keep an eye on your credit report and credit score, as they are important components in your financial health.