You may have heard someone say they turned down a raise because it would push them into a higher tax bracket and they would take home less. That is almost never true. Understanding why takes five minutes and helps with every pay decision you make.
Tax is charged in slices
Most income tax systems are progressive, with several bands. Each band has its own rate and applies only to the slice of income that falls inside it. A lower band covers the first part of your income, the next band the next part, and so on. Moving into a higher band means only the extra income above the line is taxed at the higher rate, not everything you earn.
The two numbers
Your marginal rate is the tax rate on the next unit of income you earn, such as the next pound or dollar. Your effective rate is your total tax divided by your total income. Because the lower slices are taxed at lower rates, the effective rate is always below the marginal rate. A typical worker might have a marginal rate of 22 percent but an effective rate in the teens.
A simple example
Imagine a made-up system with two bands: 10 percent on the first 20,000 and 20 percent above that. A person earning 30,000 pays 2,000 on the first slice and 2,000 on the next 10,000, a total of 4,000. That is an effective rate of about 13 percent even though the top rate they meet is 20. If they receive a 1,000 raise, only that extra 1,000 is taxed at 20 percent. They keep 800 more.
Where the myth comes from
The myth has some real roots. Some systems have steps where an allowance, a benefit or a credit is reduced as income rises, which can make the effective rate on part of your income unusually high. Examples include child benefit charges, student loan thresholds and the withdrawal of tax credits. These can create zones where a raise is worth less than it looks, but it is still very rare for a pay rise to leave you with less money overall. The details depend on the country, so check an official source or our calculator for your own figures.
Using this when you make decisions
When you are offered overtime, a bonus or a raise, think in terms of the marginal rate. Add the extra pay to your income in our calculator and see how much of it you keep. This is also the number to use for deciding how much to put into a pension: contributions made before tax effectively come off your top slice, so they cost less than they seem.
What to remember
Higher bands apply only to the income above them. Your effective rate is lower than your marginal rate. A raise almost always increases take-home pay. And if you suspect you are in one of the unusual zones, look at the numbers rather than guessing.
Calculators for this guide
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- Self-Employed? How Much Should You Set Aside for Tax
- Asking for a Raise: Using Take-Home Numbers to Plan the Conversation
- Student Loan Repayments and Your Take-Home Pay
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- All tips and guides
These guides are general information and estimates to help you plan. They are not tax advice. Rules and rates change, so check the official tax authority for your country.