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Slight Misunderstanding of Marginal Tax Brackets

Reader Ann asked the following question on my post about the 2008 Federal Income Tax Brackets [3]:

Jim ~

My husband has just been offered a salaried position of which he is excited yet somewhat reluctant about. The increase in salary would put us “over the edge,” so to speak, into the 25% tax bracket. His position probably doesn’t have much more room for increased income. We are not currently in a position to owe significantly more tax. In addition, we are quickly loosing our child deduction as they are becoming “independent.” Advice?

Here was my reply:

Hi Ann,
I think you may be misunderstanding how the tax brackets work, the listed rate only applies to dollars that exceed the low end of that tier. Your entire salary isn’t being taxed at the bracket rate. I think this is best explained using an example.

Let’s say for the sake of argument your husband earns $60,000 a year, which puts him in the 15% tax bracket at the moment. The new job has a salary of $66,000 a year, which is above the start of the 25% tax bracket of $65,100 (for married filing jointly). Only $900 of his new salary (the amount above $65,100) is taxed at 25%, not the whole $66,000.

In fact, if you were to take the standard deduction for married filing jointly of $10,900 then your income would be reduced to $55,100 and not a single dollar would be taxed at 25%. Further deductions could pull you further down the list on your marginal tax rate.

Unless I’m misunderstanding your question, I think you just had a mixup in thinking how the brackets worked.

This is a mistake many people often make when they learn about the progressive tax system. They think that “tax rate,” despite being called a marginal tax rate (thought marginal has a specific meaning not often used in conversational English), is applied to your entire income. That rate is only applied to your next dollar earned. For the 25% tax bracket, for single filers, starts at $32,550 and ends with $78,850 – you are only taxed 25% on the 32550th dollar you earn p to the 78849th dollar you earn.

In reality though, it’s even less than that because with deductions and credits, your effective tax rate is far far less. Right off the bat, single filers can claim a standard deduction that reduces their income by $5,450. If you work and contribute to a 401(k) plan, each dollar you contribute is deducted off your taxes. At the end of the year, you’ll find that your actual adjusted income is far lower than your salary, so your effective tax rate is much lower than even the aggregate of the tax brackets.