Upbeat music plays throughout.
Narrator: Have you ever heard somebody worry that getting a raise would bump them into a higher tax bracket?
On-screen text: Michael Kealy, Education Coach
Narrator: The idea that having a higher salary could somehow mean making less money sounds wrong—and it is. This fear is based on a common misconception about federal income taxes.
So, let's look at how tax brackets actually work.
The main misconception is that being in a certain "tax bracket" means that all your income gets taxed at that rate. That's not how it works.
U.S. federal income taxes are progressive, which means additional income is taxed at a higher rate. But—and here's the key—tax rates are marginal, which means not all your income is taxed at the same rate. Income is actually divided into different levels, or "brackets", that have different tax rates. Each dollar of income is only taxed at the rate of the bracket it falls into.
Think of these brackets like a series of buckets.
Each bucket holds a certain amount of money and is taxed at a certain rate. The government determines the size and rates for each bucket and usually adjusts them each year; the ones we're showing here are for 2020.
On-screen text: 2020 Single Filer: Standard Deduction
Narrator: So, suppose your taxable income was $55,000. As of 2020, the first bucket holds $9,875 and is taxed at 10%. Then, in the next bucket, you pay 12% on $30,250, and so on. The rate of the highest bucket your money starts filling is your marginal tax rate—what people often call their "tax bracket". So, in this example, only $14,875 of taxable income is taxed at 22%.
But because your income falls into multiple tax brackets, the overall rate you actually pay is typically much less than the marginal rate.
The percentage you actually pay in taxes is called your "effective tax rate".
However, determining your effective tax rate is more complicated than just taking your salary and averaging all the brackets it would fit into. That's because not all your income actually gets taxed. There are exemptions and deductions that could reduce the amount of income that's taxable. You could also get credits that reduce how much you owe. We won't get into the details in this video, but the IRS provides calculators that can help you determine your taxable income.
The important thing to understand is that your effective tax rate is the total amount you paid in taxes divided by your taxable income, which accounts for things like deductions.
So, next time you worry about which tax bracket you fall into and how big that new percentage is, remember that it's just your marginal tax rate. Your effective tax rate, the amount you're actually paying, is likely much lower.
Onscreen text: [Schwab logo] Own your tomorrow®
