Will making more money cost you? This is what the tax experts say

As a senior-level or executive professional, you can expect to be making the top of your salary pay grade. As you move throughout your career and progressively gain more responsibility and senior-level positions, your salary will inevitably increase.

However, one common misconception is that your take-home pay (or net pay) will also increase to the same degree as your pre-tax pay (or gross pay). For example, say you get a promotion at work along with a pay increase of 10% of your current salary. You may expect your net pay or take-home pay to also increase by 10%. However, this is not always the case. Why you might ask? Simple: tax margins and your taxable income level.

Ladders sat down with Bright!Tax Partner and Managing Chartered Professional Accountant  Allyson Lindsey and Jet Tax Founder, Frank Lin to discuss how earning more might cost you. 

What is the marginal tax rate?

First, it is important to understand how the United States tax system works and how this system will impact your gross and net income. The US tax system is based on marginal tax rates based on your taxable income. Depending on what your annual salary is, you will be placed in a tax bracket that indicates the percentage of your income that you will pay to federal, state, and local taxes.

As you move up in the tax brackets, the amount of taxes you will be required to contribute will grow. For many people, an increase in pay can result in being bumped into the next higher tax bracket, meaning their overall tax contributions increase as well. This might make your new promotion seem less enticing than you originally thought. 

In the US, the marginal tax rate is determined and paid by the next earned dollar of income. According to Allyson Lindsey, Bright!Tax Partner and Managing Chartered Professional Accountant, “this means that the first part of your income is taxed at a lower rate and the higher parts of income are the only ones taxed at the higher rates.”

In simple terms, your first dollar earned will be taxed at the lowest tax rate while the last dollar earned will be taxed at the highest eligible tax rate. This is called progressive taxation and is designed to ensure the highest earners are taxed at the highest level, while the lowest earners are taxed at the lowest level. It is also important to note that there can be taxation differences based on your marital status and whether you are filing your taxes as a single person, a married couple, or head of household. 

The current marginal tax rates shown in the table below were implemented on January 1, 2018, with the passing of the Tax Cuts and Jobs Act (TCJA) signed under then-president Donald Trump. Here are the current tax brackets for the 2021 tax season. 

A case study

As we mentioned above, under the current taxation model tax rates are determined progressively so you will not be paying the same tax rate on every dollar that you earn. 

For example, say you are an individual filing your taxes in 2021 and you make $200,000 annually. You can calculate your annual taxes using the following progressive model. 

• First tax bracket – ($0-$9,950) x 10 = $995.50
• Second tax bracket – ($9,950-$40,525) x 12% = $3,669.00
• Third tax bracket – ($40,525-$86,375) x 22% = $10,087.00
• Fourth tax bracket – ($86,375-$164,925) x 24% = $20,690.64
• Fifth tax bracket – ($164,925-$200,000) x 32% = $11,224
• Sixth tax bracket – Not applicable
• Seventh tax bracket – Not applicable

If you add up these amounts, you can determine an individual’s ‘tax liability’ for the year. For our case study, this individual’s 2021 taxes would be $46,666.14, pending other factors. 

Keep in mind that other factors may influence your taxes, depending on where you live. We recommend consulting with an accountant to better understand your unique tax circumstance. 

What about state taxes?

Now that we have walked through federal income taxes, it’s time to discuss state taxes. Each individual state will have its own taxation system so we encourage you to speak to a local accountant or visit your state government website.

Most states use a form of the marginal tax rate system, but some do use a flat rate taxation system. In a flat-rate tax system, individuals are not taxed on a progressive system like in a marginal tax system. For states with flat tax systems, all residents are required to pay the same amount of taxes regardless of their income. 

According to Lindsey, “the flat rate actually benefits you as you earn more money because even though your income increases, you don’t have to pay any higher tax rates.” There can be arguments for and against a flat tax rate system with equity and equality being the central themes. 

What does this mean for you?

While the marginal tax rate impacts all of us, it can certainly be disappointing when you notice a smaller increase in your monthly net income than you expected after a promotion or new job. To help combat this disappointment, we encourage you to do the calculations yourself on what a new salary could mean for your tax contributions and how this will impact your monthly income. 

When I spoke with Frank Lin, the Founder at Jet Tax, he had an interesting perspective to share. 

“People assume the higher the salary the better, but I advise clients to look at the full compensation package.  This includes all of the benefits and clauses in your contract that may not benefit you now, but may later on.  For example, having a base salary of $50,000 may not sound like much in New York, but if the package comes with health insurance, immediate vesting of a retirement plan, and equity options that you can vest within a reasonable amount of time, it may be much better than a job with only an $80,000 base salary.  This may benefit you from a tax perspective as well.  If you take a job with a $50,000 base salary and equity options that vest at your choosing, you would only need to be taxed on $50,000 in the current year.  You may decide to vest your equity options at a later date when tax laws are more favorable or your household income is in an overall lower tax bracket. “

Armed with this information, you can set clear expectations and maybe even negotiate a new salary. We highly recommend doing the calculations prior to signing any paperwork for your new job so you can properly negotiate a salary that will best fit your lifestyle, even with the consideration of increased taxation. 

For more information on the United States’ marginal tax rate system, and to determine your tax bracket, we encourage you to check out your state government website or the Internal Revenue Service (IRS) website.