Monday, April 19, 2010


Marginal tax brackets

As we’ve just had income tax time in the U.S., I’ve been hearing a bunch of silliness associated with it. I thought I’d talk about two of my favourite (well, for some value of “favourite”) tax fallacies.

It doesn’t pay for me to get a raise! It’ll just put me in a higher tax bracket, I’ll pay more taxes, and in the end I’ll wind up making less than I did before.

I haven’t worked out every possibility, and maybe there’s really a way that can happen, but I can’t imagine what it could be. The “tax brackets” in the U.S. are marginal — you only pay the higher tax on the portion of your income that put you into the next bracket.

Let’s suppose you’re single and your taxable income is $33,000 in 2009. You’re in the 15% tax bracket. A 3% increase in your taxable income would make it $33,990, and that would put you into the 25% tax bracket. 15% tax on $33,000 would be $4,950. 25% tax on $33,990 would be $8497.50. The difference is more than $3500, well more than your rise in pay!

Only, that’s not the way the tax works. In fact, for 2009 you pay 10% on the first $8,350 of taxable income, and only pay the 15% on the amount between that and $33,950. And the 25% is only levied on any amount between $33,951 and $82,250.

So, in the example above, the tax bill at $33,000 of taxable income would be 10% of $8,350 ($835) plus 15% of $24,650 ($3,697.50), totalling $4,532.50. And the tax on $33,990 would be 10% of $8,350 ($835) plus 15% of $25,600 ($3,840), plus 25% of only $40 ($10), totalling $4,685. The guy’s taxes went up by $152.50. [Corrected; thanks, Ray, for pointing out privately that I put the wrong number here.]

I’m sure he wasn’t thrilled to pay that extra money, but it didn’t come anywhere close to eating up the whole $990 raise: he still came out with more than $800 more in his pocket.

Variant 1: Yay! I’m getting a big refund this year. That’s great!

Variant 2: Oh, no! I have to pay the feds $1000. That’s horrible! I’d rather get money back.

When you get a tax refund, you have given the government a free loan of your money. On the other hand, if you get more in each paycheck and wind up paying a bit of money at tax-filing time, then you have had the use of more of your money in the interim. Doesn’t the latter seem to make more sense, when you look at it that way?

À chacun, son goût, of course, but I’d much rather pay a little bit in April, knowing that it means that my money was mine that much longer.

Some people worry that if they set it up so that they owe money, when it comes time to pay it they won’t have it to hand. An easy way to fix that is to open a bank account just for that purpose, and “withhold” your own taxes — put a certain amount into that account with each paycheck. You still have the money, and it’s earning interest for you. You can invest it any way you like, as long as you can turn it into cash by 15 April.


HRH said...

I prefer to get a refund than owing the government. Loaning my money freely to the government for 12 months, gives me a peace of mind than the alternatives. The penalties associated with owing are much higher than the interest I would receive, if the money was kept in some kind of interest bearing account. Of course investing in the market as an alternative choice, does not offer any guarantees either, that the returns (if any) will cover the penalties plus more. I have actually tried both of these options and ended up short at the end.

Nathaniel Borenstein said...

I'm with HRH. Say that the amount in question is $3000. If you view it as coming in equal amounts from each paycheck, then we're talking about an average balance for the year of $1500. If you're lucky enough to get a 3% return, that's $45 in interest that you give up by withholding too much. My peace of mind is worth a lot more than that. Money just isn't important enough to obsess about every little bit, in my opinion.

Sue VanHattum said...

Peace of mind. I agree with that. I prefer getting a refund, because if I owed money, if would be hard to pay voluntarily, knowing how much of it goes to fund war.