Individuals who want to achieve financial independence earlier in life may find it difficult to accomplish with just their normal salary. That’s why some try to find alternative means of making money, whether through extra overtime hours at work, or through side jobs and gigs.
This almost seems like a no brainer, if you want more money, you gotta make more of it. Somewhere and somehow. What comes as a surprise to many, when they receive their paycheques, is the amount of tax that is taken off. This is especially true for people that do overtime work. What might sound like a lucrative opportunity for time and a half pay usually results in a paycheck that’s a fraction of what you were actually promised to be paid. So what gives?
Welcome To The World Of Taxes
One concept that many Canadians fail to understand is how our income tax system works. Many people just complain that they pay too much tax, but rarely do we actually understand how much tax we pay and why.
Most people are familiar with looking at their paystub and recognizing that their company is deducting taxes on each paycheque. We accept it and don’t second guess the amount.
Let’s take an example of Sally. She works on annual salary of $48,000 and lives in Toronto. Sally knows she won’t receive the full $4,000 every month in her paycheque because taxes are taken away by her employer. Instead her monthly paycheque is $3,366. To her that sounds quite fair, she’s only paying around 15.9% of her salary in taxes. Not too shabby.
Now the boss comes around and offers her overtime at time and a half. That’s great! Instead of making $23/hr, Sally can make $35/hr. That extra cash could sure go a long way to paying off her debt. After working for an extra 5 weekends, on both Saturday and Sunday, she gets in an extra 80 hours. She expects to get her paycheque minus the taxes to be ($35 x 80) minus the 15.9% taxes. Right?
Well Sally is in for a surprise. Instead of getting $2354.80, she ends up getting $1997. WTF? Why did she receive so little for the extra work she did? Did the workplace end up ripping her off?
The Side Gig
Charlie is quite the musician. Every now and then him and his band gets gigs at the local pub in Toronto to play live and entertain the guests. On top of his already decent paying $48,000 job, Charlie gets an extra $150 each weekend when he plays at the local pub during the 6 warmer months
For Charlie this seems quite good. He’s getting an extra $600 per month in the summer on top of the $3,366 that he’s already making at his full time job. That extra money allows him to take a vacation when the cold winters hit. Not bad.
For Charlie, he just gets the full $600. The pub still does the proper paperwork and pays Charlie with a cheque. To Charlie, this seems like a tax free gig and it’s almost better than his full time job because he’s pocketing the full $600 for the summer months and no taxes are paid.
So is working on the side better than working overtime at the company? Charlie gets to pocket his earnings tax free. Sally who works time and a half ends up only getting around 70% of what she actually earned. Is this sexist treatment? Are women getting unfairly taxed versus men?
Understanding Marginal Tax Rates
In the scenario above, neither of the employers are doing anything wrong. First off no one is getting taxed unfairly. Regardless of gender, we all pay the same tax rates depending on the provincial territory that we live in. So let’s not pick up our phones and start bombarding our MPPs quite yet.
The reason why Sally is paying extra tax on her overtime paycheque is because that’s how much she gets tax on each additional dollar she earns. What Sally is not realizing is that Canada has a marginal tax system.
When Sally looks at her paycheque, she’s assuming she’s paying 15.9% tax on her paycheque, but that’s not true. That’s just her average tax rate. The marginal tax rate on her current salary is actually 29.65%. What does that mean? That means for every extra dollar she earns on top of her current salary, Sally will have to pay taxes at a rate of 29.65%. That’s how marginal tax rates work. It generally takes more from you on the next dollar that you earn more.
In the scenario for Charlie, his employer at the pub doesn’t know about his other full time job. So for all the manager knows, Charlie is only making $3,600 per year. This is well under the personal tax exemption of having to pay any taxes. So for the pub, they don’t care to deduct taxes from Charlie’s salary because the pub thinks Charlie only makes $3,600 a year.
But wait doesn’t this mean that Charlie is cheating the government and not paying his taxes?
It All Evens Out
Fortunately (or unfortunately for Charlie), the CRA always gets its money that is owed. That’s because every year, Canadians are forced to do tax returns. At that time, both Sally and Charlie will have to declare all their income for the year.
Sally will have to tell the CRA that she made $48,000 + $2,800 in overtime. Charlie will have to declare his $48,000 salary plus the $3,600 he made playing with the band.
At this point, Sally will not have to owe any taxes because her employer has already deducted the marginal tax rate on the extra $2,800 she made. Charlie, however, hasn’t paid his taxes on the extra $3,600 he made from the band. Come tax time, the CRA will ask Charlie for $3,600 x 29.65% or $1067.40 in taxes. This mean Charlie will have to pay taxes on his tax return.
At the end of the day. It all evens out. Regardless of how the taxes were paid on the paycheque, both Sally and Charlie end up paying 29.65% on the extra earnings they made on top of their salary.
Is It Worth It?
If the purpose of working extra hours is to make extra money, then of course working the overtime is worth it. If you’re trying to FIRE or save up for a large purchase, then working more hours and making more money is the easiest way to saving more.
The one thing to remember is that there is no way to escape taxes. Regardless if you are doing overtime, a side gig, or even getting a pay raise at your job, you will need to pay taxes on the extra dollar you earn. There is no exception to the rule.
That’s why, as you progress throughout your career and get higher pay, you will enter higher marginal tax brackets. Don’t turn down pay raises because you enter a new tax bracket. The extra taxes you are paying only affects the next dollar earned so you are still earning more money than before.
This is how the Canadian tax system tries to equal out those that make more money versus those that make less. Each dollar earned by a high income dollar is taxed more than someone making less money. That’s not to say that the take home pay of the high income earner is less than the lower income earner. That will never happen. But the penalty for the next dollar earned at higher income levels is always more painful.
This is why the average tax rate on a high income earner will always be higher than the average tax rate of the lower income earner. But this is not a reason to turn down less money or ignore a lucrative opportunity. If you are looking at earning more take home pay, always take the pay raise. If you need more money and don’t mind spending the extra time to get it, then do it. We all play under the same rules when it comes to taxes on earned income.