This week we demystify the tiered tax system and explain why you should accept that promotion.
Disclosure- This post contains either affiliate links or referral codes. If you chose to follow the links, or use the provided code, and sign up for the service, I may earn a small commission at no additional cost to you. Tools and services are evaluated relative to the value they can bring to your financial journey. The existence or lack of an affiliate program does not impact the services/tools I chose to highlight. The opinions expressed below are my own.
“My boss recently offered me a promotion. It came with a $20,000 a year raise, which would push me into a higher tax bracket. I did some calculations, realized I would lose money by accepting the promotion, and turned it down…”
It may be easy to write off the above as an exaggeration, or a simple internet meme, but the education system in the US does not universally teach the tax code. The misunderstanding of not only its myriad complexities, but of its fundamentals such as income being progressively taxed under a tiered tax system, understandably may cause confusion for many.
Table of Contents
The Tax Code is Complex and Not Well Taught
**The tax code is the United States is a complex system and unique, in parts, to an individual’s situation. I do not mean the following as advice or guidance; I mean only to explore the basic concept of a tiered system. Please always contact a professional when dealing with questions of your own. **
Without explanation, you can see how the situation above could exist. If you make $20,000 dollars more in taxable income this year than last, you may find yourself in a higher tax bracket. For someone who has never had the tax system explained, they could assume this would increase their tax burden across all income and leave them in a worse situation than they currently are in.
Enter the tiered tax system. The absolute amount that you pay in taxes will increase. However, if any or part of the additional income pushes you to the next tax bracket, the government will tax only that amount at the higher percentage. All prior income will continue to be taxed at the same level as it would have prior to the promotion. You will not be worse off financially relative to where you would have been before the additional income. Whether that extra income, taxed at your highest tax rate, is worth the time and effort it requires, is unique to the individual.
Key Idea: On a federal level The United States operates under a tiered tax system. While your income may span across multiple tax brackets, a tax rate only applies to the income within that bracket.
Deductions Under the Tiered Tax System
The IRS allows you to deduct many expenses from your income. You may itemize these qualified expenses and they will not tax this amount. Most taxpayers elect instead to take the standard deduction, which for 2021 will be equal to $12,550 for those filing as single and double this amount for those filing jointly.
If anyone can claim you as a dependent on their tax return, your standard deduction will be further limited.
What is the Standard Deduction? Why Does It Exist?
The standard deduction is an amount the Government allows all citizens to subtract from their taxable income. The standard deduction works to ensure that those taxpayers for which itemized deductions do not make sense still have a portion of their income not subject to federal income tax. Many states offer a similar deduction.
Am I Eligible to Take the Standard Tax Deduction?
There are a few conditions which may make you ineligible for the standard deduction. Intuit, the company behind the popular tax software turbo tax outlines the following situations:
- If you are married but file taxes separately and your spouse itemizes deductions on his or her return, then you can’t claim the standard deduction.
- You also can’t claim it if you (or your spouse, if filing jointly) were a non-resident alien at any time during the tax year.
- If you change your annual accounting period and file a return that covers less than 12 months, the standard deduction is unavailable.
How are tax brackets of the tiered tax system determined by the IRS
The IRS adjusts both the standard deduction, and the income levels tied to each tax bracket, yearly to offset changes in the Consumer Price Index. In its simplest form, they do this to ensure that increases in income, stemming from inflation, will not increase your tax burden.
Filing Single vs Filing Joint
In general, the income brackets for those filing jointly are simply double the maximum if one were filing jointly. This ensures fair treatment regardless of filing status. An exception does exist for the top tax bracket where it applies to taxable income of joint filers at a level much closer to single filers.
Tiered Tax System Case Study:
Let us run through a basic scenario which will illuminate the concept of tax brackets in a simplified abstract sense. I reference the 2021 federal tax brackets in this example, but please see irs.gov current requirements:
You are single and earned $98,000 of taxable income prior to the standard deduction last year:
- *Assumptions:
- We will assume you are part of the 90% of Americans which take the standard deduction.
- Process
- Begin by subtracting the standard deduction for single files (in this case $12,550) from your taxable income giving $86,375 in taxable income.
- The first $9,950 will be taxed at the rate of 10%, resulting in $995 of federal taxes.
- The next $30,574 will be taxed at 12% resulting in an additional $3,668.88 of federal taxes.
- The remaining $45,851 will be taxed at 22% resulting in an additional $10,087.22 of federal taxes.
- Your total federal tax bill would thus be $14,751.10
Here, accepting a $20,000 a year promotion (for simplicity’s sake let’s say it is $20,000 taxable so the actual promotion is slightly more) would place you into the next tax bracket.
This new $20,000 would be taxed at a rate of 24% adding $4,800 to your federal tax bill. Your tax bill would be $19,551.10. Note that is this example, the entire raise fell into a new tax bracket. I most cases part, or even all) of the new income would fall within your highest tax bracket. In that case, that portion would be taxed at your highest tax bracket. Only the amount which exceeded that brackets threshold would be taxed at a new amount.
Your tax bill has increased by $4,800 but your taxable income increased by $20,000! You should, at least from a financial perspective, accept the promotion.
Need help filing your taxes?
If you have questions regarding your tax situation please always contact a professional. If you are comfortable working through your own taxes but just wish you had a little guidance along the way there are several options to help streamline the process.
I have personally used TurboTax to file my federal and state taxes for over a decade. As a non-tax professional, I find their product intuitive to use and the process typically takes me under an hour.
Sign up for a paid federal product before Oct 15th using this link to get up to 20% off.
Questions For the Community
Where you ever thought that about the tiered tax system in school?
Questions From the Community
Have a question I didn’t address or anything you would like further information on? Leave it in the comments and I’ll address it here.