The Next Tax Bracket Myth

The Next Tax Bracket Myth

Let’s bust a myth about working overtime. Some employees incorrectly 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.

Next Tax Bracket Myth

Here’s an example. An employee makes $50/hour and works 37.5 hours per week for 50 weeks per year. That works out to $93,750 per year before taxes.

Living in Alberta this employee pays $21,736 in taxes and takes home $72,014 after-tax for an average tax rate of 23.19% and a marginal tax rate of 30.50%.

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 20 hours per month of overtime and earn time-and-a-half for those hours – or $75 per hour. Over the course of a year the employee earns an additional $18,000, pushing their total salary earned to $111,750.

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

The employee now pays $27,851 in taxes for the year but takes home $83,899 – an increase of more than $11,800. The average tax rate is 24.92% while the marginal tax rate has jumped to 36%.

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 23.19%. The employee earned an additional $1,500 from overtime work but the employer only withheld $347.85 in taxes. This results in more money in the employee’s pocket every month; however there will be a tax-bill 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% of the overtime wages, or $540 per month in taxes.

In the second example, the employee is now upset because $1,500 in overtime earnings resulted in just $960 in additional take-home pay. Extrapolate these deductions over 12 months and the result is a fairly significant overpayment in taxes.

The good news is that the employee will get a 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 $48 (before the tax refund).

Employees might look at this and determine that 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 $38.41. The actual overtime hourly rate is $48. 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. David on January 25, 2022 at 6:55 pm

    Thanks for this piece. I struggle to convince friends that the fear of moving into a new tax bracket is illusory. They’ll believe you before they’ll believe me!

    You have illustrated this seven ways from Sunday, in great detail.

    But what I need from you, as the authority to whom I will refer my friends, is just a sentence confirming that only earnings which exceed the original tax bracket will be taxed at a higher rate. That is

    $A original earning will be taxed as before at x percent.
    Only $B earnings over $A will be taxed at y percent.

    Or am I wrong?

    • Robb Engen on January 25, 2022 at 7:45 pm

      Hi David, thanks. We have progressive tax rates in Canada. The first $14,398 of income earned is tax free due to the basic personal exemption.

      Using our Alberta example, the income earned between $14,399 to $19,369 is taxed at 15%.

      Income earned between $19,370 to $50,197 is taxed at 25%.

      Income earned between $50,198 to $100,392 is taxed at 30.5%

      And income earned between $100,393 to $131,220 is taxed at 36%.

      So for the example I used, only the income earned above $100k would be taxed at 36%.

      Check out the tax tools at EY:

      Finally, we can use this information to help reduce taxes by making RRSP contributions to bring our taxable income down to the bottom of our highest marginal tax bracket.

      In our example again the employee earned $111,750 and so if they made an $10k RRSP contribution that would bring the income down to $101,750 and save $3,600 in taxes.

      • David on January 25, 2022 at 8:11 pm

        Sorry if I’m slow Robb, but does this merely mean that the higher one’s income, the bigger one’s savings are from an RRSP contribution?

        The issue I have in explaining the bracket myth to friends is that going into a new tax bracket, say from $99,999 to $100,001 does not result in one’s entire earnings for the year being taxed at 36% rather than 30.5%.

        This myth is probably so obvious to you and others that it’s not worth debunking. But I do know several well-educated people who believe it vital to ensure at all costs not to get into the next tax bracket.

        • Robb Engen on January 25, 2022 at 8:20 pm

          Hi David, I hear what you’re saying and I can see how it could be difficult to explain to someone who believes this myth.

          You’re exactly right, though. Your entire income will not be taxed at a higher rate if the top end of your income reaches a new marginal tax bracket threshold.

          If the bottom of the 36% bracket started at $100,000 and you earned $101,000 for the year, only $1,000 of your income would be taxed at 36%.

          The key phrase about your marginal tax rate is that it’s the tax rate paid on your last dollar of income earned.

  2. Jason on January 25, 2022 at 7:11 pm

    As a tradesperson I have seen this myth used to trick the gullible into turning down overtime.
    It would start like this “Oh you are just working for the government”, to which I would respond that “I will get it back after filling my taxes”.

    • Robb Engen on January 25, 2022 at 7:53 pm

      Hi Jason, I can definitely see people exploiting this myth to their advantage. Of course, in some industries they just tell you to work the overtime without any extra pay whatsoever. I think in management it’s called, “other duties as required.”

  3. Wally on January 26, 2022 at 6:32 am

    Keep in mind that when you get a higher pay cheque in a particular week, the tax deductible formula calculates taxes withheld as if this is what your weekly pay is for the year so that is why the big jump in taxes withheld at source. Or am I looking at this wrong? But you will get more money back as a tax refund for this temporary tax withholding calculation scenario.

    • Robb Engen on January 26, 2022 at 5:05 pm

      Hi Wally, that’s exactly what I suggested was happening in option 2:

      “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.”

      More money withheld at the source because payroll acts as if the extra pay is your “new normal”.

      And, yes, this would result in a larger refund at tax time.

  4. Duane on January 26, 2022 at 6:34 am

    One of my responses used to be so “so you would refuse a raise or bonus? At the end of the year it is taxed the same as overtime.” Agreed that some of the problemsay arise from how the tax is withheld on each pay cycle. Great article.

    • Robb Engen on January 26, 2022 at 5:08 pm

      Hi Duane, for sure. There could be good reasons to refuse overtime requests (better work-life balance comes to mind), but thinking you will earn less money shouldn’t be one of them.

  5. Dave Harries on January 26, 2022 at 3:41 pm

    Wally and Duane have it right. Robb, I think you’re overestimating the sophistication of payroll systems. After all, tax brackets are based on annual income and no system can know what additional overtime an employee will earn before year-end…so systems are programmed to make assumptions which most often result in over-withholding. Face it, in a society with so many people living paycheque to paycheque, the fact that it all works out when the employee files his income tax return means next to nothing.

    • Robb Engen on January 26, 2022 at 5:11 pm

      Hi Dave, I mentioned this in the article – option 2 where payroll is withholding taxes at the highest marginal rate as if you earn that high amount on a regular basis.

      You do bring up a great point that a refund months down the road means little to someone living paycheque to paycheque. Although the employee would still net more money by picking up the overtime shift.

  6. Jim R on January 26, 2022 at 11:33 pm

    Speaking of raises and taxes. Let’s for the sake of argument say you’re in the 50% marginal tax bracket. You then get a raise equivalent to one week of your pre-raise salary. Due to your tax bracket the government takes 1/2 of your raise. OTOH if you take take an extra week off during the year as unpaid leave, you get approximately (not exactly, but not too far off I think) the same salary as before, plus an extra week off. In other words, take the raise as money and you only get to keep about half, take it as time off and you get about 100% of the raise, albeit in non-monetary form.

    Bump the marginal tax bracket up to 90% (which I believe actually was the top rate in some countries at one time), and the benefit of taking the raise as time off is even more apparent. Take your marginal tax rate to a contrived and ridiculous 99.99%, and it’s obvious. An underlying assumption is that you’re RRSP contributions are already maxed out with your pre-raise salary, so you can’t reduce the tax take by throwing the extra money into your RRSP. Ditto for your TFSA contribution which wouldn’t reduce the initial tax take, but would pay off, tax-wise, later on.

    Obviously, folks who are monetarily stretched may well be willing to happily take the raise as money. But if you’re already monetarily comfortable and always short of time to indulge your hobbies, passions, etc, then taking the raise as unpaid time off seems like a no-brainer.

    Am I missing something here?

  7. FPC on January 28, 2022 at 7:08 pm

    definitely it’s an eye opener for a lot high income tax bracket earners. More taxes is directly related to more net income you actually take home.

    People focus on taxes too much, sometimes they forget to fully maximize their skill set

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