Should you ever turn down the opportunity to earn more money to avoid higher taxes?

I am often asked that question in various forms especially around this time of year when people are thinking about their taxes. Sometimes it is a question from someone considering a promotion, new job or simply taking on overtime, other times it is people worrying about making too much money in their investments or their 401K and IRAs growing so large that they will have a “huge tax burden”. Granted our tax code is way too complicated, and many people including some financial planners, don’t fully understand how it affects your investment. I even head a financial planner the other night come up with a cute (but incorrect) phrase, “Your IRA is simply and IOU to the IRS.” While it is true you owe taxes on your traditional IRA and 401k only a portion of it will go to the IRS, less than 40% even with the worst planning. How much goes to the IRS depends on how well you plan, see my next article that talks about reducing taxes through planning.  In the meantime what you owe the IRS should be looked at as an interest free loan from Uncle Sam until you have to take the money out and pay the bill. You also need to realize any stream of income from a traditional IRA or 401K is taxable income and account for that in both your retirement and tax planning. More on this in the tax planning article.

The short answer is no, you should never cut back your earnings or be afraid of making more money, either through work or investment, simply to avoid a higher tax rate. While we do have a progressive tax scheme that simply means the more money you make the more you will be taxed on the last dollar you earn. While that sounds ominous, it also means the more income you make the more money you get to keep. So if your taxes are higher that means you are keeping even more money. Hitting a higher tax bracket only affects dollars you earn after that break point, it does not go back down to dollar one that you earned. As a result there is never a scenario in our current federal tax system where making more money, even after hitting a higher tax bracket, will leave you less money or less after tax income.

This is confusing to some people so I will try and break in down in this article. Since no one wants to pay more taxes than they have to, in the next article I will try and give you suggestions and talk about the importance of trying to minimize your life time tax bill for you and your family through legitimate methods.

There are four categories of tax payer, single, head of household, married filing jointly, or Married Filing separately. The tax rate brackets are slightly different for each category and change each year. They can be found by Googling Federal income tax brackets or following the hyperlink. For simplicity I will use the Single bracket in my explanation. That is the bracket in which you hit the break points the soonest, with the exception of married filing separately that is identical to the single until the highest bracket which it reaches earlier.

The brackets only affect taxable income, so that is basically the amount of all your wages and investment income, less your standard or itemized deduction. Certain investment income such as dividends, interest, and long term capital gains, are entitled to a lower rate than your bracket, (I will discuss this in the companion article on tax management) but for purposes of this illustration we will assume all sources of income are taxed according to the brackets.

The table below gives you and illustration of how this works

bracket	break  point	Start When income reaches	End when income reaches	range	rate
Income up to $9,875	$0.00	$12,400	$22,275	$9,875	10.00%
Over $9,876 to $40,125	$22,276	$22,276	$52,525	$30,249	12.00%
Over $40,126 to $85,525	$52,526	$52,526	$97,925	$45,399	22.00%
Over $85,526 to $163.300	$97,926	$97,926	$175,700	$77,774	24.00%
Over $163,301 to $207,350	$175,701	$175,701	$220,050	$44,349	32.00%
Over $207,351 to $518,400	$220,051	$220,051	$530,800	$310,749	35.00%
over 518,401	$518,401.00	$530,801			37.00%

If you assume a standard deduction (If you itemize you simply would start paying taxes at the amount of your itemized deduction) A single person pays no income tax of the first $12,400 they earn. They then pay 10% federal income tax on the next $9,875 they earn. When their income reaches $22,276 they pay federal tax at a 12% rate until their income reaches $52,525 and so on. So your affective tax rate (divide your total tax by total income) is never anywhere near your top marginal rate, and that top marginal rate is only applied to any dollars you earn above the break point.

So if you are currently earning $97,925 dollars you’re highest, or last earned dollars, are being taxed at 22% by the federal government meaning you are keeping 78 cents of every one of the last $45,399 dollars that you earned. If you have an opportunity to earn an extra $10,000 it simply means that next $10,000 would be taxed at the 24% rate meaning you only get to keep 76 cents our of each of those new dollars, but still you would have $7,600 more in take home pay even though Uncle Sam is getting more tax dollars, and getting them at a higher rate. Even If your raise or extra income boosted you above $518,401 a year putting you into the highest marginal tax rate, that rate would only affect the dollars above the break point and you would still be bringing home 63 cents of every one of those dollars you made above a half million dollars each year.

So you may make the decision it is not worth your time to do the extra work to just to take home 63 cents on the dollar earned (you may not need the money if you are already making a half million dollars a year and time may be more valuable to you) but the decision should be based on whether you need the extra money or prefer to have more leisure time. It should not be based on your taxes being too high. More income always means more money for you to keep, at least 63 cents of every dollar under the current federal income tax rates.

If you are a 401k Millionaire, worried about doubling your money in the next ten years before you retire don’t worry about having to pay too much tax. Worst case scenario you would pay $370,000 in taxes on the million giving you $630,000 to spend after taxes. If you double you have to pay $740,000 in taxes but you would have $1,260,000 in after tax money to spend. See my next article so you can plan ways to avoid the worst case scenario. Whether you have a million or two million dollars you can minimize the amount you pay in taxes over your life time, keeping more money for yourself and family if you plan how and when to put money in, and more importantly when to take your money out of these accounts.

Of course this scenario does not include Medicare and social security tax which is taxed from dollar one but it is a flat rate and it applies to all your earned income but not to your investment income.  It also does not include any state or local income taxes you may have to pay, but most of those are flat rate and minimal by comparison to the federal rates. Even in the states with progressive and the highest income tax rates, when combined with federal income tax, you never pay more than 50% of your income to income tax. This explanation also assumes the current tax rates which are already schedule to go up at the end of 2025, and may be raised in future years to pay off our increasing deficit. However even if rates rise, you can expect the pattern to remain the same, and I would not ever anticipate a scenario in which reducing your income to lower you highest tax rate would ever result in you having more money in your pocket.

Everyone should be looking at ways to legitimately reduce their life time tax bill but particularly those people at or who are likely to be at the higher tax rates or believe like I do that taxes are more likely to go up than down in the future. But giving up income is not the answer.  The biggest percentage jump most people have to worry about currently is from 24% to 32% so ideally you want to time and manage your income wherever possible to keep below that 32% breakpoint, which is $175,701 for single filers with a standard deduction. See my companion article on minimizing your life time family tax bill and some ideas about how to avoid that rate now and when you are retired and forced to make withdrawals from your IRA and 401K.

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