Question about tax rates and overtime

Factual Questions
1

I have a friend who’s convinced that as you accrue overtime, your paycheck taxrate for your entire check goes up. So if you only work a few hours of overtime, you actually lose money, as a higher rate takes effect and back-applies to your normal pay. So you should either not work overtime at all, or work enough (10+ hours, he thinks) that you end up making more money after the loss from the taxes. He specifically said that he knows a lot of people who refuse to work any overtime as to avoid falling into this trap.

Of course I know this is almost certainly wrong. Our whole marginal tax system is basically set up so that you can’t make less money from generating more income/doing more work.

But he said that he definitely makes less per hour than you would expect based on his overtime pay. I said I think the tax rate is the same no matter how many hours or how much overtime. So we grabbed one of his pay stubs.

The payroll taxes were basically the same rate to within a rounding error. But on a check where he worked about 12 hours of overtime, he had a federal withholding rate of about 13.6%. On the next check, when he worked about 28 hours of overtime, he had a federal withholding rate of 14.8%. So there wasn’t just more money withheld because he worked more hours - the actual rate of the taxes increased.

What’s the reason for this? As far as I know, there isn’t a per-paycheck tax rate. You set your withholding target at the beginning of the year (or when you get the job, I forget) based on what you expect your deductions to be at the end of the year as to try to match your actual tax bill. And from that, a federal withholding rate, a percentage, is generated to hit that target. So your federal withholding rate should be the same from paycheck to paycheck. But it isn’t in this case.

The paychecks were back to back, so it wasn’t a withholding or tax rate change. One of them did have 8 hours of holiday pay - is that something that would affect tax rates? Those 8 hours were included in the total gross pay, which is how I got the percentages - federal taxes withheld divided by total gross pay.

So anyway, am I correct that you can’t make less money due to taxes by working more hours? Is he correct that there’s some sort of per-paycheck rate, and either your overall tax rate goes up as you work more overtime, or the overtime itself is taxed at a greater rate? What explains the difference in federal withholding?

2

Yep.

Kinda.

Let’s say that we have a simple tax bracket system where every week, the first $1000 you earn is taxed at 10%, and from $1001 to $3000 is taxed at 15%.

Now, suppose you earned $1500 that week. How much tax do you pay?



$1000 x 0.10 = $100
  500 x 0.15 =   75

So you paid $175 in taxes, which is roughly 11.66% of your $1500.

What if you earned $2400 that week?

Now your taxes are:



$1000 x 0.10 = $100
 1400 x 0.15 =  210

You paid $310 in taxes, which is roughly 12.9% of your paycheck. So your effective rate went up.

Paycheck withholdings are calculated using a table of approximate effective rates based on your deductions and the amount you earned that pay period. Since tax brackets are progressive, the effective rate that you pay increases gradually the more you make.

3

I bet you and your friend both get a refund at the end of the year. Nothing personal, most people do. I think the average refund is creeping up to near $3000. It gets bigger each year.

You can’t really say how much tax you pay by looking at the amount withheld from a single check. You have to take into account how much of a refund you are going to get and adjust for that. Comparing two paychecks is like going to the store and buying a gallon of milk this week with a $10 bill and buying a gallon next week with a $20 bill and complaining that the price of milk has doubled. You also have to look at how much change the cashier gave you back from your $10 bill or $20 bill.

The amount withheld for taxes from each check is an estimate. Unless you fill out your W-4 form with great care and precision (most people just use the number of exemptions on their 1040 which doesn’t produce a great result) and you make exactly the same amount each and every week for the whole year, it turns out that it is a very bad estimate. But when you fill out your tax forms (Form 1040) at the end of the year, it produces the correct result and you settle up with the government by getting a refund or by sending them more money.

Your withholding rate is not set once a year, it is set for each paycheck. If somebody earns $100 in their weekly paycheck, the amount of tax that gets withheld is based on the assumption that they will earn $5200 a year. If somebody earn $1000 in their weekly paycheck, the amount of tax withheld is based on the assumption that they will earn $52,000 a year. So if your check amount varies from week to week, the amount that gets withheld will vary considerably. Working overtime causes your checks to vary. Hence the bad estimates of how much must be withheld. One week when you don’t work overtime, the withholding will be based on the assumption that you are a low-wage worker. Next week when you do work overtime. the withholding is based on the assumption you are a high-wage worker.

But then, at the end of the year, all of the checks are added together and the amount you actually should have paid is calculated, and you get a refund (or have to pay extra).

4

There may be a small benefits or taxes that apply suddenly, so that for very small ranges you can actually go backward.

Here if your income is over around $70,000 you pay 1% more tax (health care cost …if not exempt… complications to ignore… ). So lets suppose it is exactly $70,000.
Then for the range $70,000 to $70,700 you might profit by reducing your taxable income… eg you tell your boss not to pay you $400, because you gain $300 by not taking the $400… Or you make a charitable donation that you claim as a tax deduction, and reduce your income down to $69,999…

So that $1 could cost $700… The tax on that one dollar is astronomically high, but the average tax isn’t changed significantly enough (to continue on with calculatons)… as the total at risk is only $700

5

Even if the withholding is greater for the entire amount on single check, that would be reversed when the full year tax is calculated on the entire year’s wages.

The only other thing I can think of is if you itemize, and some deductions are based on a percentage (say 2.5%) of the annual income. But that is not the case for most people.

6

This is the reason, spot on. When you work overtime, you trick the IRS into thinking you make more money than you really do. So they jack up the collection rate. At the end of the year, when you settle up with the government and they see you didn’t make as much as that one paycheck made it look like, you get a big refund.

It’s well known in my industry that bonuses get swallowed by the IRS and you don’t get it until next April. If you get a one-time $1000 bonus, the IRS acts like you got a $12,000 raise and takes about half of it.

7

I just had three checks in a row with over time. The extra money that I earned each two week period was taxed at a higher rate, but the money for the 80 straight straight time hours was taxed at the same rate. If I want to calculate the tax rate for the OT pay it is simple. Subtract the base pay from the total pay. This will give me the amount of extra pay. Then subtract the base tax amount on earlier checks from the tax paid on the OT check. Now divide the Extra pay into the extra tax multiply by 100 and that will be the percentage that the extra is taxed at. For me that is over 30%. That leaves me 70% to pay SS and state taxes. I normally get to keep about 52% of my OT. If your company is taking out more than what your earned extra then the book keeper does not know how to properly do the taxes. Oh yes because the extra taxes taken out this month, it means that I will probably get a larger tax return nex Feb.

8

Yes, make him read up on marginal tax rates. The main negative of higher wages if it it reduces/removes a credit/deduction, or dings AMT.

The IRS also doesn’t know that you work multiple jobs, so multiple W-2s can really screw up your withholding if you don’t play ahead. If they’re higher paying, you will also pay too much in social security tax, but there is a way to get that refunded, but have to wait until next year, obviously.

Bonuses are withheld at 25%, or 39.6% if over $1m. On the the IRS often gets this info separately, e.g. on a 1099, so it is taxed separately. If it is a continually accruing bonus, it might be counted as regular income and added as such to the W-2/

And even these require you to spend lots. Like more than that on work supplies not provided by your employer, with specific restrictions (no, a suit is not a work expense). Or the medical deductions, which have required you to have some very serious illness or very little income.