Understanding Tax Brackets

The United States uses a progressive tax system, which means that income is taxed in layers, with different portions of your income taxed at different rates. These rates are divided into what we call “tax brackets.”

How Progressive Taxation Works

Imagine your income is like a multi-layered cake. Each layer of the cake represents a portion of your income that falls within a specific tax bracket, and each layer is taxed at a different rate.

Here’s a basic example using hypothetical tax brackets:

• 10% tax rate for income from $0 to $10,000

• 12% tax rate for income from $10,001 to $40,000

• 22% tax rate for income from $40,001 to $85,000

Marginal Tax Rates

The key concept here is the marginal tax rate. This is the rate that applies to the last dollar you earn and falls within the highest tax bracket you reach based on your income.

Effective Tax Rates

Your effective tax rate is the average rate you pay on your total income, not just the rate from your highest tax bracket. It’s calculated by dividing your total tax liability by your taxable income.

The Misconception

A common misconception is that once you move into a higher tax bracket, all of your income is taxed at that higher rate. This is not true. Only the income that falls within that bracket is taxed at the higher rate.

An Example

Let’s say you earn $50,000 a year. Here’s how your taxes would be calculated:

• The first $10,000 is taxed at 10% (the lowest bracket).

• The next $30,000 (from $10,001 to $40,000) is taxed at 12%.

• The remaining $10,000 (from $40,001 to $50,000) is taxed at 22%.

Your total tax would be the sum of these three parts, not just 22% of $50,000.

Conclusion

Moving into a higher tax bracket only affects the income that falls within that bracket. The rest of your income is still taxed at the lower rates, which means that a raise or additional income will not result in less overall income after taxes.