How Tax Brackets Work
Taxes. Everybody hates them but we all have to pay them. Some people more than others. We've all heard the stories of the mega-rich avoiding income tax altogether They can do this because they understand the ins and out of the tax code (well, maybe they pay people a lot of money to do this for them) and understanding how taxes work will prove invaluable for you in keeping more money in your pocket.
An often misunderstood component of taxes is the concept of marginal tax rates, or "tax brackets" for us lay people. Most people will tell you that the more you earn the more you'll pay in tax. While this is true, not every dollar you earn is taxed at the same rate, at least not in Australia, America and a lot of other developed countries.
I created an Instagram post explaining tax brackets a while back that went viral (for me at least) and reached over 120,000 people. Who knew the people loved taxes so much?!
In that post I laid out how the federal tax rates apply for USA, Canada and Australia. The overwhelming majority of viewers loved seeing the breakdown of how it all works and how the 3 big countries compared to one another.
This is the post I am talking about:
Every dollar earned is not taxed at the same rate
One of the first things you'll notice is that not all income is taxed at the same percentage rate. Put simply, the lower your income, the lower the tax rate. As you start earning more, the tax rate begins to rise in tranches until you hit the highest earning level. Every dollar earned after the top tier will be taxed at highest rate.
In Australia, all income earned under $18,200 is tax free. From $18,201 up to $45,000, every dollar in that range is taxed at 19%. From $45,001 up to $120,000, every dollar in that range is taxed at 32.5% and so on.
It works much the same in the US and Canada, however they have state and provincial taxes thrown on top of the federal taxes, and those taxes vary depending on the state and province.
Is moving to a higher tax bracket worth the effort?
I often hear a lot of people say "I don't want to earn more because I'll be pushed into the next tax bracket". This can come from the false understanding that if you sit in a higher tax bracket then all of your income is taxed at the higher rate. We know that this isn't true and I stated this in the section above.
In saying that, if you currently sit in the 37% tax bracket in Australia and you then get a pay rise that moves you into the 45% bracket, you begin to ask yourself is the extra effort worth it? That's definitely a personal question that only you could answer.
If the pay rise that pushes you into the higher tax bracket requires you to work more hours, spend more time away from your family or puts a strain on your mental health, it mightn't be worth the extra money.
However if the pay rise comes with a few extra responsibilities, a chance for you to grow either personally or professionally (or both), or opens up opportunities to further your career, then to me it makes sense to jump at the chance to earn a bit more money - even if the extra dollars are taxed at a higher rate.
How much federal taxes will you actually pay?
We know that the US and Canada have state and provincial taxes, respectively. So the examples below will only look at the federal taxes to keep things simple. In Australia, we only have the federal level tax on income and it doesn't vary by state.
The tables below are based on a single person filing their taxes as an individual. If you're married or "head of household", the dollar ranges will vary. For simplicity, I've only shown the federal tax brackets based on an individual.
Tax brackets based on 2021 rates (2020 for Canada, because it matches my IG post, and well, OCD)
You'll see how someone earning $80,000 will pay the most federal taxes in Australia. However, the full tax burden in the States and Canada will need to factor in their state and provincial taxes, which would push their taxable income higher (in specific states and provinces).
How to get into a lower tax bracket, even when earning more
I wrote an article a while back for 5 Ways to Minimize Your Taxes, in which I mention that contributing to your retirement account is a great way to lower your tax burden. Accounts such as the 401(k) in the US, your RRSP in Canada, or Superannuation here in Australia.
You can contribute up to $25,500 of pre-tax dollars into your Superannuation account each year. If you were to take advantage of this, your taxable income will be lowered by the same amount of what you contribute. The current mandatory contribution to Super is 10% of your gross income each year.
Let's say you got a pay rise from $110,000 and would now be earning $140,000 in Australia. That means your Super contribution would 10% of the $140,000, which is $14,000. Your tax rate for every dollar earned above $120,000 would be taxed at 37%.
If you were to contribute an additional $10,000 to your Superannuation account, your adjustable taxable income would now be $118,000. That means that no portion of your new annual salary would be taxed at the higher 37% tax bracket.
So not only do you get a good tax break, you'll also be building wealth for the future. Win win!
This is just one way (and a good one) to lower your tax even if earning more.
The progressive tax system means we'll pay progressively higher taxes the more we earn. It's important to remember that not every dollar earned is taxed at the same rate under this system.
As you start earning more and potentially moving up the tax tiers, you'll want to understand how much you'll be paying in taxes and the effective strategies you can put in place to minimize the taxes you pay.
Consider how your life will be impacted if you seek a pay increase. If you find you'll be working more hours to earn an extra buck and this will negatively impact your life, perhaps chasing a higher salary isn't worth it for you. However, if you love the idea of earning more money and understand how this may change your tax situation, then go for it!
Whatever you decide, you'll now be more aware of how taxes work and be better equipped to make a decision that will suit your personal situation.
Blake - FIRE with a family