I’m shocked at how frequently people make this money mistake.
I’m referring to a common misunderstanding of how income tax rates work.
Many people say some variation of the following: “You don’t want a higher income because you’ll jump up into a higher tax rate and end up actually taking home less money after tax.” People have even refused career advancements based on this misconception.
This line of thinking is pure poppycock. Hogwash. It’s a fundamental misunderstanding of how marginal tax rates work.
I can understand why people make this mistake. After all, marginal tax rates do increase as you earn more income. What people don’t understand is that the higher marginal tax rate ONLY applies to the income earned above certain thresholds.
To help illustrate, here’s a simple example: Let’s say the marginal tax rate on the first $50,000 earned is 20%, and above $50,000 the marginal tax rate jumps to 25%. Based on this tax structure, if you earn $70,000 you pay 20% tax on the first $50,000 and 25% tax on the next $20,000.
What people mistakenly assume is that once (using the above example) they earn above $50,000 they’ll pay 25% tax on everything.
Simply put, regardless of higher marginal tax rates the more income you earn the more you take home after tax.
A Real-Life Example
The four tables at the bottom of this post provide real-life examples of this for residents of each of the ten provinces in Canada. The detailed tables show after tax income, average tax rate, marginal tax rate, etc. on income levels of $50,000, $75,000, $100,000 and $125,000. For the purposes of this exercise, the only column you need to pay attention to is the ‘After-Tax Income’ column.
In case you don’t want to go through each detailed table, I’ve summarized the results for an Ontario resident below. Here are the after tax incomes for all four income levels:
Income: Before and After Tax for Ontario Resident
|Income Before Tax||Income After Tax||Marginal Tax Rate|
As you can see, as you earn more income you take home more after-tax money, despite a higher marginal tax rate.