Should I Be Worried Earning Too Much Will Bump Me into the Next Tax Bracket?

With tax season in full swing, many taxpayers find themselves scratching their heads over the complexities of the U.S. Federal income tax system. We're going to break down how federal income tax rates apply to a middle-class family earning $250,000 annually, and why earning “too much” isn’t as bad as you think.

The Basics: Progressive Tax System

First things first: the U.S. uses a progressive tax system. This means that as your income increases, so does your tax rate – but only on the additional income. You don't pay the highest rate on all of your income. Instead, your income is divided into "brackets," each taxed at a different rate. It's like climbing a ladder; each rung represents a new tax bracket. For the 2024 tax year (what you owe by April 2025), there are seven tax brackets: 10%, 12%, 22%, 24%, 32%, 35%, and 37%.

Meet the Johnsons: A $250,000 Family

Let's introduce the Johnsons, a married couple with two kids, filing jointly with a combined income of $250,000. Here's how their income would be taxed in 2024:

10% on the first $23,200 of taxable income
12% on income between $23,201 to $94,300
22% on income between $94,301 to $201,050
24% on income between $201,051 to $250,000

Before we calculate tax owed, let's not forget about deductions.

The Standard Deduction

For tax year 2024, the standard deduction for married couples filing jointly is $29,200. As a Married Filing Jointly taxpayer, you subtract the standard deduction right off the top of the total income. This means the Johnsons' taxable income is actually $220,800 ($250,000 - $29,200).

Crunching the Numbers

Now, let's see how this breaks down when it comes to tax owed:

10% of $23,200 = $2,320 tax owed
12% of ($94,300 - $23,201) = $8,531.88
22% of ($201,050 - $94,301) = $23,484.78
24% of ($220,800 - $201,051) = $4739.76
Total tax: $39,076
Effective tax rate: 15.6% ($39,076 / $250,000)

But Wait, There's More!

The Johnsons may be eligible for credits like the Child Tax Credit, which could further reduce their tax bill. Plus, if they contribute to retirement accounts or have other deductions, their taxable income could be even lower. Lower taxable income means less tax owed overall.

The Takeaway

Basically, there is NO downside to earning more money. You won't end up with less money, so you shouldn't be worried about earning more. Only $19,749 of the Johnsons' $250,000 in earnings hit the 24% bracket. While the Johnsons' total income falls into the 24% bracket, their effective tax rate is much lower at 15.6%. This illustrates the utility of the progressive tax system – you're not paying your highest rate on all your income, just on the portion that lies in that bracket.

Understanding how tax brackets work can also help you make informed decisions about other aspects of your finances (e.g. whether or not it makes sense to convert pre-tax Traditional IRA assets to Roth IRA assets). But remember, tax laws can change, and individual situations vary. Always consult with a tax professional for advice tailored to your specific circumstances.