What’s Your Marginal Rate?

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Not too long ago, I used to work for minimum wage in my spare time lightwalking for the Canada Opera Company. What lightwalkers do is stand on the stage wearing some neutral colours as the lighting designer and crew adjust the lighting to make sure faces are lit and unintended shadows are mitigated. Reason: it’s cheaper than having the actual opera singer stand there doing nothing.

The gig was fun. I’d work a 4 hour shift one weekend and pocket $44 and get to hang out on the majestic stage of the Four Seasons Centre in Toronto and rekindle my love of theatre.

But one day I stopped altogether. Why? Because my marginal tax rate caught up to me. Let me explain.

What is the marginal tax rate?

As the wonderful taxtips.ca defines it, your marginal rate is “A person’s marginal tax rate is the tax rate that will be applied to the next dollar earned.  This is quite different from the average tax rate, which will be much lower.”

To put that into numbers, if Jane Doe makes $50,000 in Ontario, her average tax rate is 16.41% (averaged across all the tax brackets based on her income), while her marginal rate is 29.65%. That means if she makes an extra $100 somehow, then $29.65 will be owed to the tax man leaving her with just $70.35.

So why’d I quit my side hustle?

My marginal rate started to climb. When I used to stand on a stage for minimum wage, I was a recent graduate and my income was only ~$45,000. Combined with my tuition tax credits I had accumulated across my MBA, I basically was paying ZERO tax.

Then those credits soon ran out and my income rose until I hit the 43.41% marginal rate.

That meant if I worked for $11 an hour, I’d really only take home $6.22 an hour after tax. In the context of side hustles, by the time I commuted down, perhaps unfrugally bought lunch (because it’s the weekend supposed to be a fun and social day), I’d probably make close to nothing.

Whenever I make “new” money, I always think marginal rate first.

My philosophy is whenever I make taxable income, I’m thinking post-marginal rate.

Take for instance EQ Bank’s 2.3% high interest savings account versus TD’s 1.35% High-Interest Savings Mutual funds. At first glance, the 2.3% looks pretty great since it puts you ahead of the 2% target inflation rate by a 0.3%.

However, when you factor in a 43.41% marginal rate, it looks something like this:

EQ Bank:
2.3% * (1-0.4341) = 1.3%

All of a sudden, your 2.3% isn’t beating inflation. It’s not even keeping up. And even though TD’s High-Interest Savings mutual fund isn’t any better, in a registered account like a TFSA or RRSP, you’re ahead by 0.05%. It’s still something!

Keep aware of Certain Income Exceptions

Note that not all income is subject to your marginal rate. Capital gains (50% of your marginal rate) and dividend income (depends on your tax bracket) have special tax treatments which can be quite favourable.

This method isn’t foolproof…

There are some people who like to consider their RRSPs on an after-tax basis. Personally: this is a fruitless exercise as attempting to predict what your retirement income looks like unless you’re less than 5 years away from calling it quits. The best you can do is be cognizant of what your future income looks like and plan RRSP deductions accordingly (for one, I’ve gathered a significant amount of deductions that I will initiate this year being in the 43.41% marginal rate).

Considering income on an after-tax basis also isn’t particularly effective for anyone below the personal exception rate (since you pay no tax) or new graduates since they’ll be in new jobs and have tons of tax credits that have accumulated.

If anything: don’t overthink it. Just know what your marginal rate is (link is to a tool) and do the math on if earning a bit extra on the side is worth your time after tax. You’ll feel smarter about knowing what you actually make and be more aware of what your tax bill might look like at the end of the year.

 

 

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Author: stretchingeverydollar

Starving artist to Debt Free MBA. Attempting to retire early.

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