The Next Tax Bracket Myth

The Next Tax Bracket Myth

Let’s bust a myth about working overtime. Some employees wrongly believe that when earnings from overtime, a bonus, or salary increase pushes them into another tax bracket they’ll actually take home less on their paycheque than before.

Some employees even refuse to work overtime because they believe they’ll pay more taxes and earn less money in the end.

I’m sure you’ve all heard of the next tax bracket myth.

Here’s an example. An employee makes $40/hour and works 37.5 hours per week for 50 weeks per year. That works out to $75,000 per year before taxes.

Living in Alberta this employee pays $16,818 in taxes and takes home $58,182 after-tax for an average tax rate of 22.42 percent and a marginal tax rate of 30.50 percent.

The marginal tax rate is important because it’s the amount of tax paid on an additional dollar of income.

Here’s where the next tax bracket myth comes into play.

The employee is asked to work 25 hours per month of overtime and earn time-and-a-half for those hours – or $60 per hour. Over the course of a year the employee earns an additional $18,000, pushing their total salary earned to $93,000.

How does this affect the amount of taxes paid? Let’s take a look:

The employee now pays $22,442 in taxes for the year but takes home $70,558 – an increase of more than $12,300. The average tax rate is 24.13 percent while the marginal tax rate has jumped to 36 percent.

Problems with overtime earnings occur depending on how much tax the employer withholds at the source. This can work one of two ways:

  1. Source deductions are applied as if the employee remains at an average tax rate of 22.42 percent. The employee earned an additional $1,500 from overtime work but the employer only withheld $336.36 in taxes. This results in more money in the employee’s pocket every month; however there will be a large tax-bill of approximately $1,600 owing at tax time, resulting in an unhappy employee.
  2. Payroll can, however, withhold a greater amount of tax at the source in the case of a bonus or overtime earnings. For this example let’s say the employer withholds 36 percent of the overtime wages, or $540 per month in taxes.

The employee is upset because $1,500 in overtime earnings resulted in just $960 in additional take-home pay. Extrapolate these deductions over 12 months and the employee pays $23,298 in taxes.

The good news is that the employee gets an $856 refund at tax time.

Origin of the next tax bracket myth

My gut feeling is that the second scenario is more common and employees see more taxes deducted at the source when they work overtime or get a bonus.

Related: 5 myths about insurance

Some back-of-the-napkin math shows that the employee’s actual hourly rate for the overtime worked was just $38.40 (before the tax refund).

Employees might look at that and think picking up overtime is not worthwhile because they’ll earn less than their regular hourly rate after taxes. Enter the next tax bracket myth.

But this is simply not true. You can’t take the after-tax hourly rate and measure it against a pre-tax hourly rate. You have to compare apples-to-apples.

The employee’s regular hourly rate after taxes is $31.03. The actual overtime hourly rate is $41.25. Sure, it’s not exactly time-and-a-half. But the employee is clearly making more money working overtime regardless of the shift into the next tax bracket.

Final thoughts

Some people are confused about the difference between their average tax rate and marginal tax rate. Your average tax rate is simply the amount of tax paid divided by your income.

Related: 9 money myths experts wish you’d stop believing

Since Canada has a progressive tax system your average tax rate will always be lower than your marginal tax rate.

So just because a raise or another source of income bumps you into the next tax bracket doesn’t mean ALL of your income is now taxed at that rate.

Consider this myth busted

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  1. Financial Canadian on September 26, 2016 at 6:42 am

    This is a myth that people often talk about, but I’ve never read it broken down to simply before. Great post.

  2. Carlos Henao on September 26, 2016 at 7:59 am

    I’ve heard this myth before from a client, but I didn’t realize it was a widespread belief! When people refuse overtime or more work when they need the money, I think you can accurately say “A little knowledge is a dangerous thing”.

  3. Stephen Weyman on September 26, 2016 at 10:13 am

    I’ve heard people talk about this before too – always made me chuckle a little bit.

    If you get a really large bonus or work a ton of overtime in a single pay period, it can look REALLY bad tax-wise if they deduct taxes like you will be earning that amount for the entire year. Some employer tax programs do the math that way as you showed.

    It can look even worse than your example – but the fact remains they’ll just be in for a large refund when they file their taxes.

  4. JoeTaxpayer on September 26, 2016 at 10:30 am

    You are kind to use the word “myth” vs “ignorance”. We have a similar, graduated rate system in the US, and it’s amazing how many people make the mistakes you discussed here. I try to break it down to the simplest words – marginal rate is the cents you pay on the next dollar you earn.

  5. Bruce on September 26, 2016 at 11:05 am

    I have addressed this math myth countless times with my comrades, but in addition, I also explain how the entire O/T take-home earnings tend to be 100% disposable income (since your cost of living bills are already covered by your regular earnings), and therefore, it is the ‘funnest’ money you can earn. I encourage folks to consider the question, why leave work at precisely the moment the rate of pay goes up.

  6. Denis on September 26, 2016 at 1:41 pm

    There is always the other myth about hating to pay tax at tax time. I try to shout that you want this as this is money lent to you by the government instead of tax refund = tax government borrowed from you.

    Further paying more tax is good as you are earning more.

    Funny financial psychology, ain’t (sic) it?

    • Carlos Henao on September 26, 2016 at 2:51 pm

      I’ve heard this one before and I definitely understand it.

      But after having given some associates finance advice, I started realizing this is just as much a psychology game as it is a numbers game.

      One thing most people are terrible at is budgeting.

      So think about those same people that, once it’s tax time, find that they owe taxes instead of being owed by the government. What do they do?

      Typical is that at a minimum they stress about this situation.

      But I don’t have all the answers. Paying at tax time still makes sense in terms of Net Present Value, and all that. I’ve found I don’t have many short term options investment nowadays to take advantage of paying less taxes throughout the year.

      So question is, aside from the generic advice, what do you do and why does it make sense to you?

      • Denis on September 27, 2016 at 5:36 am

        Since you replied to my post, I assume it is to me. I am a retired IT manager and now, for once, can use my financial acct degree in managing my money.

        Most of my income is cap gains and so at tax time, I usually pay tax at tax time. So the more tax I pay, the better I have been doing. Since retiring 5 years ago, my net worth has gone up in spite of this low rate environment, BUT if you have been investing, hard not to make money.

        This has been my best year by far so I should have a stiff tax bill and maybe next year, I may have to pay tax by installment. We shall see.

  7. Joe on September 28, 2016 at 7:40 am

    I think this myth also confuses people about RRSP.

    I’ve read comments by people saying that we should use deductions to reach the bottom of our current tax bracket and not more. I’ve also seen people state we should use the deductions just enough to drop into a lower tax bracket.

    What’s your take on it?

  8. Dave on October 3, 2016 at 7:25 am

    Overtime may not be all that it is cracked up to be. A better question is to ask, “what am I giving up for those extra hours of work?” This is especially true if you still have kids at home. The additional money you earn will not substitute for the quality time lost with your children or spouse. Achieving balance in life is always a challenge.

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