How brackets work
Federal income tax is marginal, meaning each slice of income is taxed at its own rate. Suppose, in invented round numbers, that the first $10,000 of taxable income is taxed at 10 percent, the next $30,000 at 12 percent, and everything above $40,000 at 22 percent. A person with $50,000 of taxable income owes $1,000 plus $3,600 plus $2,200, or $6,800. The marginal rate is 22 percent, but the effective rate is 13.6 percent. A $1,000 raise costs $220 in federal tax and leaves $780. The real thresholds depend on filing status and are adjusted by the IRS every year, and the IRS publishes the current table.
Taxable income comes first
Brackets apply to taxable income, not to salary. Traditional 401(k) contributions, HSA contributions and health premiums come off first, followed by the standard deduction, which also changes annually. A person earning $60,000 may be taxed on far less. Social Security and Medicare taxes are a separate matter, a flat 7.65 percent from the first dollar of wages. Most states add an income tax of their own, and a handful levy none.
What withholding is
Your employer uses your W-4 and the IRS tables to estimate your annual tax as though every paycheck of the year looked like this one. Your return compares the amount withheld with the actual tax. A refund is your own money returned without interest, and a $3,000 refund means you went without $250 each month. Owing a modest sum is harmless. An underpayment penalty generally applies only when you owe $1,000 or more and your withholding covered less than 90 percent of this year's tax and less than 100 percent of last year's.
When withholding goes wrong
- Two jobs, or two working spouses, cause underwithholding, because each employer applies the low brackets and the standard deduction as if its paycheck were the only one.
- Freelance or investment income has nothing withheld at all.
- A bonus is withheld at a flat supplemental rate that may not match your own, and the difference is settled at filing.
- A job that starts mid-year is overwithheld, since payroll assumes twelve months at that pay.
The repair is the same each time. Run the IRS Tax Withholding Estimator with a recent pay stub, then give your employer a new W-4, which takes effect within a pay period or two.
Tip Check your withholding every summer and after any marriage, birth, home purchase or job change. A correction made in July is spread over many paychecks, and one made in November is not.
