Tax Myth Buster Series: Going Into a Higher Tax Bracket Makes Working Not Worth It

Tax Myth Buster Series

Going into a Higher Tax Bracket Makes Working Not Worth it

By Wayne M. Lenell, CPA, PhD

Statement of Tax Myth:

I'm not working any overtime because the extra wages will put me in a higher tax bracket and I'll end up making less money than not working the overtime.

The myth in the statement above is that, while tax rates increase with higher incomes, the higher rate does not apply to all wages, only the wages in the higher tax bracket. The taxpayer believes that if he or she is in the 12% tax bracket, and earns more by working overtime to push taxable income into the 22% tax bracket, that all income will be taxed at 22%. If that were true (but it's not), the taxpayer would be correct by avoiding extra wages.

The truth is that the income for each tax bracket is "protected." Federal income taxes are graduated in brackets. This is termed a progressive tax schedule since the more one earns, the higher the percentage of tax is applied. The 2020 Federal tax brackets for single (not head-of-household) taxpayers are as follows:

Tax Bracket

From To Tax Rate

$ 0 $ 9,875 10%

$ 9,876 $ 40,125 12%

$ 40,126 $ 85,525 22%

$ 85,526 $163,300 24%

$163,301 $207,350 32%

$207,351 $518,400 35%

$518,401+ 37%

For example, a single taxpayer earns $25 per hour. Based on a 40-hour workweek, the taxpayer will earn $52,000 for the year. After the 2020 standard deduction of $12,400, taxable income is $39,600. From the tax bracket chart above, the taxpayer is in the 12% tax bracket. This doesn't mean, however, that the full $39,600 will be taxed at 12%. The first $9,875 of income will be taxed at 10%. It is "protected" from the 12% tax rate. Therefore, the taxpayer will pay $988 on the first $9,875 of taxable income, and $3,567 on the next $29,725 of taxable income for a total Federal tax of $4,555 on $39,600 of taxable income.

In the "Statement of Tax Myth," the taxpayer was worried about earned overtime pushing the taxpayer in a higher tax bracket. Using the same example of a taxpayer earning $25 per hour, assume the taxpayer had the opportunity to earn an additional $1,000 of overtime for the year. The gross income before overtime was $52,000, but after subtracting the standard deduction of $12,400, the taxable income was $39,600. The overtime would increase the taxable income to $40,600 which, according to the tax bracket chart, is in the 22% tax bracket. With a taxable income of $39,600 before overtime, the taxpayer is $525 below the top range of the 12% tax bracket. This means that the first $525 of overtime is taxed at 12%. Only the amount in excess of $525 is taxed at 22%.

The taxpayer may choose not to work the overtime because the taxpayer does not want to pay a 22% Federal income tax rate even though the 22% applies to only part of taxable income. That is certainly the right of the taxpayer. For example, before Ronald Reagan was governor and president, he was a popular Hollywood actor in the late 1930s and extending through the early 1960s. Post World War II, the highest Federal tax rates exceeded 90%. President Reagan reportedly told his chief of staff that he chose to loaf around rather than make more than two movies per year. Because of the tax rates, President Reagan asked, "What good would it have done me?" Recognizing that in 1951, the highest Federal tax rate was 92%, and the highest California tax rate was 6%, he would have netted 2% tax­ home pay after taxes for starring in additional films. He decided that it wasn't worth his efforts for 2% of his gross pay. While the top Federal tax rate in 2020 is "only" 37%, the same concept applies, that is, the greater the tax rate on increased earnings, the less incentive there is to work. With lower Federal tax rates, though, the "penalty" for earning more is far less than in previous generations.

Continuing with the example of a taxpayer earning $25 per hour, while in the 12% Federal tax bracket, an extra hour of work would yield $18.96 per hour subtracting Federal, State (assuming Colorado's current 4.5% tax rate) and Social Security/Medicare taxes. If that person's earnings bumps up to the 22% tax bracket, his or her net pay would decrease (only on the incremental hours) to $16.46 per hour.

When deciding whether it is "worth it" to earn extra money when the opportunity arises, it is also important to consider other aspects of taxes. In addition to Federal and State income taxes, a taxpayer is subject to Social Security/Medicare taxes on earnings. If a taxpayer qualifies for a premium tax credit on health insurance premiums, additional income may reduce the amount of tax credit. Likewise a person who qualifies for the Earned Income Credit may lose some or all of the credit as a result of additional income. Though not literally a tax, a person collecting Social Security benefits between the ages of 62 and full retirement age may have benefits reduced as a result of additional income.

Conclusion. While the concept of losing money for working extra is a myth (now busted), it is true that the more a taxpayer earns, the higher the percentage of tax on the incremental earnings.