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:
- 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.
- 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.
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.
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.