Earning a salary increase is definitely one of the best things anything can happen to any hard working individual and if you’re one of those who recently got a raise, well done! You deserve it! It is indeed a great feeling to recognize for your work. Unfortunately, your raise comes with several tax implications and you may have to face a potential hit for the tax year. You will fall into a new tax bracket, therefore, your income is going to be taxed at a much higher rate. Does it mean you won’t be going home with a higher paycheck? Well, that’s really not always the case. One of the common misconception taxpayers think is that all of their income will be taxed when in fact it’s only just a portion of their income is taxed at a higher rate. Here’s a quick breakdown of how getting a raise affects your taxes.
First, you need to learn about the different tax terms in order to really understand how your raise will affect your tax liability. Once these terms are explained, it will be easier for you to calculate your taxes owed based on your recent salary increase.
Progressive Tax System. The U.S tax system is a progressive system in which the tax rate increases as the taxable base amount increases.
Marginal Tax Rate. Every additional dollar a taxpayer earns will subject to a Marginal Tax Rate. To understand how a marginal tax rate works, here’s an example: You present salary before the raise is $34, 500 per year which will then put you to the 15% marginal tax bracket. The IRS will then calculate base on the bracket, will have you pay $850 plus 15% of the amount you make over $8, 500. The amount over $8, 500 you make is $26, 000 so you there owe the IRS $850 and $3, 900 for a total of $4, 750.
Effective Tax Rate. Base on the given example above, you have a marginal tax rate of 15% but your average rate of tax you paid on your income in total is lesser than that. The said average rate of tax you pay is the effective tax rate.
Calculating Your Tax Liability Based On Your Raise
Now we are going to calculate what happens with your taxes based on your raise. Let’s say got a large $10, 000 raise. It will significantly add more to your current salary which would mean from $34, 500, you now have a salary of $44, 500 starting this year. How much exactly are you going to pay in taxes based on these figures? Since we already calculated how much your tax liability is for the first $34, 500 income you make, we now have to figure out how much you will pay for the salary increase amounting to $10, 000. Your total income now pushes you up into a different tax bracket so you will have to pay a marginal tax rate of 25% only for the $10, 000 salary increase. Therefore, your tax liability will be $2, 500 for the $10, 000 and will bring you to a total of $7, 250. Your effective tax rate has increased from 13.8% to 16.3% which is very much lower than the $25%.
The conclusion here is yes, you will be paying a bit more taxes because of the salary increase you got this year but you will still be able to take home a large amount of it. Don't worry if the calculation feels complicated for you to understand because the IRS website provides all the information about your tax rate based on your income. There are so many experienced tax professionals you can hire as well to do the calculation for you. Don’t forget, your salary increase will also give you a chance to take a closer look at your taxes as well as possible deductions and awesome credits. Lastly, even though you pay different amount of tax on different portions of your income due to your salary increase, you really won’t pay rate tax on all of your income. Don’t believe the myth you’re hearing in the streets and don’t be afraid of getting a raise because the IRS says everything still works to your advantage!
