04 · Topic
A higher tax bracket does not mean a pay cut.
Key numbers
Marginal vs effective rate, in one diagram
The marginal rate is the rate on your next dollar. The effective rate is the rate on all your dollars. They are almost never equal.
US federal brackets for a single filer in 2025 (the standard deduction of $15,000 is subtracted before brackets apply):
| Bracket | Taxable income range | Rate |
|---|---|---|
| 1 | $0 – $11,925 | 10% |
| 2 | $11,925 – $48,475 | 12% |
| 3 | $48,475 – $103,350 | 22% |
| 4 | $103,350 – $197,300 | 24% |
| 5 | $197,300 – $250,525 | 32% |
| 6 | $250,525 – $626,350 | 35% |
| 7 | $626,350+ | 37% |
Worked example: $60,000 salary, single filer
Gross income: $60,000. Standard deduction: $15,000. Taxable income: $45,000.
Stack the taxable income into the brackets one at a time:
| Bracket | Portion | Rate | Tax |
|---|---|---|---|
| 1 | $11,925 | 10% | $1,193 |
| 2 | $33,075 | 12% | $3,969 |
Federal income tax owed: $5,162. Marginal rate: 12%. Effective rate (tax / gross): 8.60%.
Most people, asked their tax rate, name the marginal number. The effective number is what actually leaves your account.
FICA: the tax most people forget about
Payroll tax (Federal Insurance Contributions Act) funds Social Security and Medicare. It is flat and applies to every dollar of wages, with one cap.
- Social Security (OASDI): 6.2% on wages up to $168,600 (2025 cap). Employer pays a matching 6.2%.
- Medicare: 1.45% on all wages, no cap. Employer matches. An additional 0.9% Medicare surtax applies above $200,000 for a single filer.
Total employee payroll tax: 7.65%. If you are self-employed, you pay both halves, 15.3%, but you can deduct half of that as a business expense. People who switch from W-2 to 1099 are often surprised by this; it is the biggest single change in net pay.
Deductions vs credits
Both reduce what you owe. They are not interchangeable.
- A deduction reduces taxable income. A $1,000 deduction in the 22% bracket saves you $220. In the 10% bracket, it saves you $100.
- A credit reduces tax owed directly. A $1,000 credit saves you $1,000, regardless of bracket. Credits are more valuable per dollar.
- A refundable credit can drop your tax below zero and pay you the difference (Earned Income Tax Credit, Child Tax Credit up to a limit). A nonrefundable credit can only zero out your tax (the Lifetime Learning Credit, for example).
Roth vs Traditional break-even
Both 401(k) and IRA come in two flavors. The difference is when you pay tax.
- Traditional: deduct contributions now, pay tax on every dollar withdrawn in retirement.
- Roth: contribute post-tax dollars now, withdraw tax-free in retirement.
The break-even rule, ignoring contribution limits and edge cases: contribute Roth when your marginal rate today is lower than your expected rate in retirement; contribute traditional when it is higher. A 22-year-old in the 12% bracket who expects to retire in the 22% bracket should choose Roth. A 50-year-old earning $300k in the 32% bracket who plans to retire on $80k should choose traditional.
There is a hidden Roth advantage: the contribution limit is the same for both ($7,000 for IRA, $23,500 for 401(k) in 2025), but the Roth dollar is worth more because all of it is yours. Maxing $7,000 in a Roth puts more after-tax money behind the contribution-limit wall. For high earners who can fit the limit either way, this argues for Roth at the margin.
Worked break-even
$6,500 contributed today. 30 years at 7%. Result: $49,500. Traditional, retired in the 22% bracket: $38,610 after tax. Roth, retired in any bracket: $49,500. The Roth wins because the future rate (22%) exceeded the deferred rate (12% in this person's working years).
Short-term vs long-term capital gains
Sell an investment held for one year or less and the gain is taxed at your ordinary income rate (10–37%). Sell after holding more than one year and the gain is taxed at the long-term rate:
- 0% if your total taxable income is under $48,350 (2025 single)
- 15% from $48,350 to $533,400
- 20% above $533,400
Worked: $10,000 gain on a stock you bought 11 months ago, marginal rate 24%. Sell now and you pay $2,400. Wait one month and sell, and you pay $1,500. That is $900 for 30 days of patience.
What the tax code is actually optimizing for
The tax code is mostly a set of incentives. Owning a home (mortgage interest deduction), saving for retirement (401(k), IRA, HSA), starting a business (Section 199A, expensing rules), paying for college (529 plans, AOTC, LLC), getting married, having kids. Every one of these comes with a tax break. The wealthy do not have a secret loophole. They have an accountant who knows which incentives line up with the life they are already living.
Of life's two certainties, only one is negotiable.
Common mistakes
- 01Believing a raise will drop your take-home pay because 'it bumps me into a higher bracket'. Only the dollars above the threshold are taxed at the higher rate. Your old dollars are taxed the same as before.
- 02Confusing deductions and credits. A $1,000 deduction in the 22% bracket saves you $220. A $1,000 credit saves you $1,000.
- 03Forgetting state tax. Federal-only calculations understate your true tax bill in California, New York, Oregon, New Jersey, and 38 other states by 3–13%.
- 04Holding stock for 11 months. Selling at month 12 (short-term) taxes the gain at your ordinary income rate. Selling at month 13 (long-term) taxes it at 0%, 15%, or 20%. The same gain. Vastly different tax.
- 05Maxing a traditional 401(k) in a year you barely paid any tax. The pre-tax deduction is worth your marginal rate today. If your marginal rate is 12% and will be 22% in retirement, you are choosing the worse deal.
FAQ
Will a raise that pushes me into a higher bracket lower my take-home pay?+
No. Only the dollars above the new bracket threshold are taxed at the higher rate. Every dollar you already earned is taxed exactly as before, so your take-home pay always goes up when your salary goes up.
What is the difference between a tax deduction and a tax credit?+
A deduction lowers your taxable income, so a $1,000 deduction in the 22% bracket saves you $220. A credit lowers the tax you owe directly, so a $1,000 credit saves you the full $1,000 no matter your bracket.
Should I choose a Roth or a Traditional account?+
Choose Roth when your marginal tax rate today is lower than the rate you expect in retirement, and Traditional when it is higher. A 22-year-old in the 12% bracket who expects to retire in the 22% bracket should pick Roth.
Why does holding an investment for more than a year matter?+
Gains on assets held one year or less are taxed at your ordinary income rate, up to 37%. Hold for more than a year and the long-term rate of 0%, 15%, or 20% applies. On a $10,000 gain at a 24% marginal rate, that patience is worth about $900.
Further reading
Tax-Free Wealth
by Tom Wheelwright
An aggressive read written for business owners. Skim the chapters on entity structure; the framework on incentives in the tax code is correct and useful.
J.K. Lasser's Your Income Tax
by J.K. Lasser Institute
Reference book published yearly. Not for cover-to-cover reading. When you have a specific question, this answers it.
The White Coat Investor
by James Dahle
Written for physicians but applies to anyone in a high-income W-2 job. The chapters on tax-advantaged accounts are the cleanest treatment available for free or near-free.