When we teach about Federal income taxes, students often assume that when one earns more income and enters a higher tax bracket, the new higher marginal tax rate applies to all of their income. When Horowitz told one student that the marginal rate only applies to the income earned within each tax bracket, the student was amazed and said he would talk to his father about it. A week later, the student spoke to Horowitz again and said his father, who owned a small business, told him that he often earned less to avoid moving to higher brackets.

The U.S. income tax system is progressive, which means that when one earns more, the tax rate is higher. However, before the government taxes one’s income, the taxpayer subtracts a standard deduction to obtain their taxable income. (We’ll ignore the option to itemize deductions.) In 2024, the standard deduction was $14,600 for single filers and $29,200 (2*$14,600) for married couples filing jointly. In 2024, the single filer pays 10% on the first $11,600 of taxable income, 12% on taxable income from $11,601 to $47,150, and 22% from $47,151 to $100,525. If married filing jointly, the brackets are twice the rate for single filers; one pays 10% on the first $23,200, 12% on income from $23,2001 to $94,300, and 22% on income from $94,301 to $201,050.

For example, if a single person earns $60,000, her taxable income is $45,400 ($60,000-$14,600). The first $11,600 of her $45,400 in taxable income is taxed at 10%, resulting in taxes of $1,160. The next $30,800 ($45,400 – $14,600) is taxed at 12%, resulting in $3,696 in additional taxes for a total federal income tax liability of $4,856 ($1,160 + $3,696) or 8.09% of her income. Of course, these don’t include other taxes such as Social Security, Medicare, and state taxes.

Let’s say our single earner gets a raise, so her earnings go to $80,000. Her taxable income is now $65,400 ($80,000 – $14,600). She has crossed into the 22% bracket. But she still owes 10% on the first $11,400, 12% on the next $33,550 (from $11,600 to $47,150), and 22% only on the next $18,250 ($47,150 to $65,400) for a total federal income tax liability of $9,441 ($1160 + 4266 + 4015) or 11.8% of her income. The higher marginal tax rate only applies to the taxable income in that tax bracket, not her entire income.

Understanding how tax brackets work is essential to good decision-making.