itshalfempty

There are a couple fairly common misunderstandings about taxes that annoy me. I don’t know exactly how common these beliefs are, but I hear them from time to time - and sometimes from people who I would think should know better!

Tax Brackets

The more income a person has, the more they pay in federal income taxes. The tax rate isn’t flat though, and instead the US uses a progressive, marginal tax system. There is an increasing tax rate applied to taxable income - for 2023 that rate ranged from 10% to 37%.

Some people don’t understand though that these tax rates are applied only to income that falls within that bracket. Instead, they think that they are taxed at 10% if they were to bring in $11,000 in 2023, but they would be “moved into the next tax bracket” and taxed at 12% if they made one more dollar.

In reality, the difference in tax paid making $11,000 vs $11,001 is basically the same. Only the additional $1 is taxed at 12% - the first $11,000 is taxed at 10%. It works this way all the up through the bracket to the top, so that making more money always results in bringing in more money. A raise, bonus, working more hours, etc., would never result in less money after taxes – at least not from income tax rates alone. The IRS has a pretty nice graphic that explains how this works.

(There are definitely cases where making more money can disqualify someone from receiving benefits or qualifying for deductions, even though the value of those benefits are significantly higher than the additional income. This scenario is pretty bad, and provides a pretty strong incentive for people to underreport income on their taxes or to avoid generating any income in the first place. That said - losing benefits isn’t typically what people refer to when they talk about being taxed in a higher bracket.)

This misunderstanding is pervasive enough for some people to turn down raises, reject job offers, avoid working overtime, or underreport income on taxes just to avoid being taxed at a higher rate.

Tax write-offs

Something I’ve heard even more commonly is a misunderstanding for how tax deductions work. I’ve heard this most often when people dismissively play down the value of charitable contributions, especially by businesses, because they are done “as a tax write-off”. While (qualifying) business expenses and charitable donations are effectively “pre-tax”, there’s really no financial benefit for spending that money.

Deductions (or “write-offs”) reduce taxable income. There are lots of categories for deductions, and a lot of rules that govern what is deductible. But deductions effectively reduce taxes owed. That said - deductions are generally for money that was spent - meaning you can avoid paying income tax on money spent on something that is effectively not taxable. But to get the deduction, you still have to spend the money.

As an example, let’s just say a person had $60,000 in income and is taxed at a flat 25%. Let’s consider a hypothetical difference between including a deduction for a $5,000 charitable donation.

While the deduction reduces the total taxes paid, it doesn’t increase the amount of money that is kept after taxes. By donating $5,000 to charity, this person would still end up with $3,750 less. Spending money still means you spend money, even if you don’t pay taxes on it.

(There are deductions that don’t require spending money. These exist for a wide variety of reasons, but can sometimes be exploited as a “loop hole” that can help businesses or people avoid taxes in very significant ways. These situations aren’t what people refer to when they talk about “business expenses” or “write-offs”.)