How to understand marginal tax rates.
"Will you keep less money if you get a pay raise into the next tax bracket?"

Happy Halloween!

Income taxes are one of those things that, even though everyone needs to do them, most people don't know much about them. Particularly when it comes to understanding "tax brackets".

"Will you keep less money if you get a pay raise into the next tax bracket?"

Tax brackets are a term used to describe the different tax rates in a progressive tax system like we have in Canada. In simplified terms a progressive tax system means that people with higher taxable income pay more taxes than those with lower taxable incomes.

For example, if you live in New Brunswick, and you earn $49,000 per year at your job in 2021, your combined (federal and provincial) marginal tax rate is 29.82%.

Now, if you were to get a $1,000 pay raise, bringing you to earning $50,000 per year, your new marginal tax rate would be 35.32%.

Some people see this, and they do a bit of math and say…."wait a second. If my tax rate was 29.82% on my $49,000, then I was paying $14,612 in taxes, and taking home $34,388. But if I get my raise, then I will be in a 35.32% tax bracket. Which means I would pay $17,660 in taxes, and take home only $32,340. This is less than $34,388!! So I would actually keep less! Right??"


What they left out the key word "marginal" tax rate. This means that it is the tax rate charged on every dollar above the previous tax bracket, but not on the whole amount.

 Let's break it down using this same example and with the provincial tax rates from EY.com for 20211. Check these out for your province here: https://www.ey.com/en_ca/tax/tax-calculators

Before your raise, your tax bracket is between $43,835 to $49,020. For this bracket EY.com shows the following: Basic Tax = $7,632. Rate on excess = 29.82%.

What this means is that for your first $43,835 of income, you pay $7,632, and then you pay 29.82% on every dollar above $43,835, up until you exceed $49,020. So in our example when you're earning $49,000, your tax payable would be $7,632 + $(49,000-43,835)x29.82% = $9172.20. Note that this is less than what was assumed above, and is actually a total effective taxation rate of $9172.20/$49,000=19%. You get to bring home $39,828.

Now, in the example where you earn $50,000, which is in the next bracket ($49,021 to $87,861), you'll understand that you are only paying the 35.32% tax rate on the amount between $49,021 and $50,000. So the 35% rate only applies to $979 of your income. Not on the whole $50,000. This results in a tax payable of $9,523.78. Your total effective taxation rate is 19.05%, and you certainly don't keep less than before. $50,000 minus $9523.78 is $40,476.

So yes, even though you pay more taxes the higher amount you earn, at no point do you make less than you would on a lower salary. Benefits and credits or other special circumstances are being ignored here for simplicity.

If you were avoiding that next raise, or holding out on doing a money-making project on the belief that you will lose some of your existing earnings to tax, forget it! Forge ahead now that you know that you'll just end up with extra income. Don't let the tax tail wag the income dog.

As usual, your specific situation may differ and nothing in this post is meant to be construed as personalized investment advice for you.

And, if you happen to get a raise, think about saving the difference instead of increasing your spending. If you keep your spending where it was every time you earn more money, you can really fast track your FI journey!

1 https://assets.ey.com/content/dam/ey-sites/ey-com/en_ca/topics/tax/tax-calculators/2021/ey-tax-rates-new-brunswick-2021-06-15-v1.pdf  2021-10-31.

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