New Here? Get the Free Newsletter

Oblivious Investor offers a free newsletter providing tips on low-maintenance investing, tax planning, and retirement planning. Join over 9,000 email subscribers:

Articles are published Monday and Friday. You can unsubscribe at any time.

Income Tax 101: Tax Brackets and Withholding

To date, there are 573 posts published on this blog on a fairly wide variety of topics. Despite that, approximately half the email questions I receive deal with either tax brackets or withholding. As far as I can tell, these questions stem from the fact that many (most?) taxpayers do not understand:

  1. How tax brackets work, and
  2. How the amount withheld for taxes from one’s paychecks can be different from the amount of tax one actually has to pay.

Let’s take a crack at each of those, shall we?

How Do Tax Brackets Work?

Based on the 2012 tax brackets, we can see that for an unmarried taxpayer, the 10% tax bracket goes from $0-$8,700 of taxable income. For example, if John’s taxable income is $8,700, his income tax will be $870. Nothing tricky there.

But what if John’s taxable income increases by $1 to $8,701 (thereby putting him in the 15% tax bracket)? How much extra income tax will John pay?

Answer: He’ll pay an additional $0.15 of income tax. That is, only his final dollar of income (the dollar that’s in the 15% tax bracket) will be taxed at 15%. His first $8,700 of income will still be taxed at 10%.

Important conclusion #1: Getting a raise at work that puts you into a higher tax bracket will not reduce your after-tax take-home pay. (Possible exception: The raise could make you ineligible for certain deductions or credits, the loss of which could outweigh the increase in income.)

Important conclusion #2: If you’re trying to get an estimate of how much income tax you’ll owe for a given year, do not simply multiply your income by your marginal tax bracket–doing so would overestimate your tax (by a very wide margin in many cases).

How Does Withholding Work?

From every paycheck, your employer withholds some of your salary/wages to go toward taxes. The Federal government requires this because they understand that many people spend every dime that makes it into their bank account (plus some). By making withholding mandatory, Uncle Sam gets his money before taxpayers have a chance to spend it.

It’s important to note that the amount of tax that’s withheld over the course of a year goes to more than just Federal income taxes. It also covers:

  • Social Security tax (6.2% of your earnings, up to $110,100–temporarily reduced to 4.2% for 2012),
  • Medicare tax (1.45% of earnings), and
  • State income tax (if applicable).

In addition, the amount that’s withheld over the course of the year for Federal income tax will not actually equal the amount that you’re responsible for paying that year. This is the result of the fact that your employer doesn’t have all of the information necessary to precisely calculate the tax that you’re responsible for paying. (For example, they don’t know what deductions you’ll claim or how much your spouse earns.)

The fact that the amount that’s withheld does not equal the amount you’re responsible for paying is why tax season is basically a massive “settling up,” during which taxpayers either receive a refund (for the amount by which their withholding exceeded their tax) or write a check to the U.S. Treasury (for the amount by which their tax exceeded their withholding).

For More Information, See My Related Book:

Book6FrontCoverTiltedBlue

Taxes Made Simple: Income Taxes Explained in 100 Pages or Less

Topics Covered in the Book:
  • The difference between deductions, exemptions, and credits,
  • Itemized deductions vs. the standard deduction,
  • Several money-saving deductions and credits and how to make sure you qualify for them,
  • Click here to see the full list.

A testimonial from a reader on Amazon:

"Very easy to read and is a perfect introduction for learning how to do your own taxes. Mike Piper does an excellent job of demystifying complex tax sections and he presents them in an enjoyable and easy to understand way. Highly recommended!"
If you want to discuss this article, I recommend starting a conversation over at the Bogleheads investing forum.
Disclaimer: By using this site, you explicitly agree to its Terms of Use and agree not to hold Simple Subjects, LLC or any of its members liable in any way for damages arising from decisions you make based on the information made available on this site. I am not a financial or investment advisor, and the information on this site is for informational and entertainment purposes only and does not constitute financial advice.

Copyright 2013 Simple Subjects, LLC - All rights reserved. To be clear: This means that, aside from small quotations, the material on this site may not be republished elsewhere without my express permission. Terms of Use and Privacy Policy