Have you ever heard someone say, “I don’t want to work too much overtime because it’ll put me in a higher tax bracket”? Or this classic, “I don’t want to get too big a raise, because I’ll just have to pay more in taxes”?
I used to hear statements like these from friends and colleagues when I was in my 20’s and 30’s, but surprisingly I still hear similar comments today from professionals in their 40’s and 50’s.
The root cause is a common misunderstanding about how income taxes actually work.
I know, taxes are boring, I get that. But this is important, and not complicated, so please continue!
The sad thing is that this misunderstanding could cause a person to pass on thousands of dollars in additional income per year, and that could add up to hundreds of thousands of dollars over the course of a career.
Let’s not let that happen.
But, before we go further, how about a nice disclaimer? I am not an accountant or an expert on taxes. I am simply reviewing some basic concepts. If you need advice on taxes, please do your own research or seek professional advice.
You can find answers to a lot of tax questions at TaxTips.ca (no affiliation). The site is a great resource and I highly recommend checking it out.
Two key definitions
These are the main tax rate terms you need to be aware of and understand how they’re different.
Marginal Tax Rate – This is what you hear referenced in the media most often in regards to income taxes. Or, if you hear someone complaining about how high their taxes are, they’re most likely talking about their marginal tax rate (whether they know it or not).
Marginal Tax Rate = the tax rate on the last (or next) $1 of income you make
Average Tax Rate (aka Effective Tax Rate) – This is the tax rate you almost never hear people talk about. But it’s actually more important, and more relevant to you, in understanding how much of your income is actually going towards taxes.
Average Tax Rate = total tax paid ÷ total income
Simple, right?
So why, you may ask, do people get confused about tax rates?
Tax Brackets
One source of confusion is the way Federal and Provincial tax brackets are structured and the way they work together… or more accurately, the way the DON’T work together.
Federal tax brackets for 2023:
Federally, there are officially only 5 tax brackets. However, there’s a non-refundable tax credit on the first $15,000 of income earned (reduced at higher income levels). So effectively, the tax rate is 0% on the first $15K at the federal level. To reflect this, and for simplicity, I’ve included this as the 1st tax bracket at 0%.
2023 provincial tax brackets. Example: Ontario
The provinces are able to come up with their own tax brackets and tax rates. You would think that for simplicity, they would want to line up their brackets with the federal brackets, but… NOPE!
Let’s take a look at Ontario as an example.
Provincial tax brackets vary significantly across the country in terms of the bracket boundaries and tax rates. But you can get a sense of how they look based on the Ontario example. It’s important to note, though, that Ontario is one of only two provinces to sneak in an additional surtax (not included above), which grosses up these tax rates at higher income levels.
It begs the question, why not just be transparent and build these higher tax rates into your tax brackets? I guess the Ontario government prefers to keep the picture somewhat cloudy… and complicated!
Combined Federal and Ontario provincial tax brackets for 2023
In order to determine what our TOTAL tax rate is at various income levels, we need to combine the federal and provincial brackets along with any surtaxes.
Of course, this creates a ridiculous number of brackets.
13 tax brackets! Crazy!
As you can see, tax rates are pretty high at the highest levels, but keep in mind that these are MARGINAL tax rates.
Getting back to the big mistake
If you live in a province other than Ontario, you’ll probably have fewer brackets. But overall, you can get the gist of what the combined federal and provincial tax brackets can look like based on the example above.
Now, let’s get back to that mistake people often make when looking at these brackets.
Let’s say you make $50,000 per year. You might look at the brackets above and determine that your tax rate will be 24.15% (bracket 4).
So, total income tax would be: $50,000 x 24.15% = $12,075
Now, let’s say you could make an additional $5,000 per year by working some overtime each week, for a total of $55,000.
Looking back at the brackets, you might think that would increase your tax rate to 29.65% (bracket 5).
In this case, total income tax would be: $55,000 x 29.65% = $16,307.50
So, in this scenario, of the extra $5,000 you make working overtime, you only take home (after tax) an extra $767.50! Not very motivating!
BUT WAIT! THAT’S NOT HOW IT WORKS!!!
In the scenario above, we’re confusing the MARGINAL tax rate, with the AVERAGE tax rate (or Effective Tax Rate).
As mentioned earlier, the tax rates detailed in the brackets above are MARGINAL tax rates.
In reality, with an income of $50,000, the first $11,865 is taxed at 0%, then the next $3,135 is taxed at 5.05%, and so on as follows:
Note that for simplicity, I’m leaving out some additional charges and deductions. Factoring those in, the total tax due would be slightly lower. For a more precise estimate, I highly recommend the Income Tax Calculator at TaxTips.ca. They have calculators for each province and territory.
Based on the calculation above, you can see that the actual federal and provincial tax due would be about $7,200. Significantly less, than the $12,000 calculated previously.
And at $50,000 in income, the average tax rate is about 14.4%. Much better!
Now, what if we decided to work the extra overtime and boost our income to $55,000?
Here’s what the tax calculation would look like.
With income increased by $5,000 to a total of $55,000, income tax will total about $8,505. An increase of $1,298.
Meanwhile, our average tax rate increased only slightly to 15.46%
So, of the additional $5,000 earned, our take-home pay would increase by about $3,702 ($5,000 – $1,298). Almost 75% of the additional income earned stays in our pocket!
Now that provides much more motivation to work extra hours and/or go for that raise in salary!
Conclusion
Don’t make the mistake of confusing your MARGINAL tax rate with your AVERAGE tax rate!
Making this mistake is likely to cause you to make sub-optimal, and downright erroneous, decisions regarding earning additional income.
Over time, these poor decisions can seriously limit you from progressing in your career, and in life in general.
Ultimately, this error could cost you hundreds of thousands of dollars (maybe even more!) in additional income and wealth generation over a lifetime.