Marginal tax rates - why working more doesn’t lead to earning less

Understanding marginal tax rates is a key component to personal finance - mainly because the path to financial independence is to maximize after tax earning or minimize expenditures. I’ve heard people say they don’t want to work overtime hours or accept a nominal raise because “then I’ll be in a new tax bracket and I’ll take home less”. Unfortunately, while these people have the best intentions and the right goal of focusing on take home pay - by not understanding marginal rates they are hindering their ability to maximize their earnings.

So let’s talk a bit about income tax - for the sake of simplicity I am going to ignore capital gains and dividend tax, as well as RRSP contributions and other deductions to reduce income. While these are all important items and can be used to manage your tax burden, it frankly takes the topic from eye-glazing to overwhelming when we’re getting started.

So why do we pay income tax? In case there are any fellow history nerds, the first income tax in Canada was imposed in 1917 as a temporary measure to finance World War I. The legislation evolved from the Income Tax War Act through time, and in 1948 the Income Tax Act was passed to create a permanent ongoing measure to collect taxes to help fund public expenditures that are important to Canadian social and economic policies.

There are lots of different income tax systems, all with their pros and cons, but in Canada we use a marginal tax rate system - where higher levels of income are taxed at a higher level than lower incomes. The reason for this is that at lower income levels families just simply need a higher percentage of their income for necessities, and the government recognizes this and keeps taxes lower at lower income levels, but in turn asks higher income earners to pay a higher portion. Let’s start with federal tax, as that doesn’t change no matter where you might be in Canada!

Personal Basic Amounts

Personal basic amounts are the first dollars of income you earn, that are subject to non-refundable tax credits that make them essentially tax-free. Yep, you heard that right, both provincially and federally there are some levels of income that are not subject to any income tax. Let’s be clear though, this isn’t any incentive to not earn above this amount, it’s sufficiently low that if you are earning below this amount, every dollar taken out will have an impact. In 2021, the federal basic amount is $13,808 (unless you earn over $151,979 - we will come back to that later) and the Alberta personal amount is $19,369.

As you can see, the higher your income, the higher your tax rate. The important thing to note though, is that Canada employs a stepped rate.

What this means is if you were earning $48,000 and you get a raise to $50,000, your first $13,808 is subject the personal basic amount credits to be effectively taxed at 0%, the next $35,212 is taxed at the 15% level still, and

only the last $980 is taxed at the higher rate of 20.50%. So at $48,000 you would pay $5,128.80 in federal income tax for a take home pay of $42,871.20. Your marginal tax rate (the amount you are taxed on your next dollar of earnings) is 15%, but because of the personal basic amount your average tax rate is 10.69%. After your raise, you would pay tax of $5,482.70, and have a take home pay of $44,517.30. Even though your next dollar of earnings is taxed at a higher rate, there is no retroactive adjustment to your earlier earnings, so while your marginal tax rate has increased to 20.50%, at $50,000 your average tax rate is still 10.97%.

While moving to a higher income tax bracket will reduce the amount from each additional dollar you take home, your overall take home earnings will still increase.

Provincial Tax Rates

While the example above only utilized federal tax rates, unless you are a non-resident of Canada (which is beyond today’s scope) you will also need to pay provincial taxes. These work in the same manner as federal tax rates, but are set by each province and therefore will vary depending on where you live. To make tax calculation easier, most income tax tables will show a combined federal and provincial tax table based on your province of residence - as

shown here (with the new brackets due to the inclusion of provincial tax for Alberta highlighted in red).

Even though the impact of taxes becomes larger with the addition of provincial taxes - because there is no regressive taxation to lower income net income still grows steadily.

One More Twist - Basic Personal Amount Claw Backs

Now, if you aren’t cross eyed yet - I did note above that the federal basic amount changes if you earn over $151,979. The federal basic personal amount is $13,808 as long as you earn below the $151,979 tax bracket threshold. If you earn above that, a portion of the personal basic amount is clawed back as your income increases, until it reaches $12,421 at the highest income tax bracket threshold.

Ultimately if your federal marginal income tax bracket is below 29% your personal basic amount is $13,808 and if your federal marginal tax bracket is 33%, your personal basic amount is $12,421. In between, there is a portion of the basic amount that is clawed back, relative to your income. The overall impact is fairly small, and it is worth noting that even if you move into the income brackets where you see this reduction to personal amount, your net income still increases along with your gross income - at no point does this claw back have a negative impact to earnings.

If you take one thing and one thing only from this, please let it be that you will not be reducing your take home pay by accepting a higher wage or salary, due to income taxes. However, if you are receiving income tested benefits (such as childcare benefits or OAS), these may be impacted by increasing income. You will want to speak with your Financial Advisor about how this will impact you, and if there is anything you can do to mitigate the impact. Generally speaking though, if someone wants to pay you more or you can get additional hours, absolutely go for it! There are plenty of ways to put those funds to good use, whether its paying down debt, building up your savings, or protecting your downside risk with insurance (more information to come).

Elyce Harris is a CFA Charterholder working with Cornerstone Investment Counsel, a registered ICPM in Alberta, Canada. She is also a licensed insurance broker in Alberta, Ontario, and PEI. While every effort is made to ensure the accuracy of statements, errors may occur. If a specific stat or carrier policy is cited, a source will be provided, however some opinions / generalizations have been provided without a specific source.