Liam Croke: Why it pays to know what your real taxation rate is

How much tax are you really paying? I received an interesting email from a reader last week, asking me whether an increase in his salary as a result of him possibly taking on a new role within his company was going to justify him applying for it – and accepting if offered the promotion. The new role, in his own words, whilst exciting, was going to involve longer hours and a lot more responsibility. He was just not sure if it was going to be worth it.

How much tax are you really paying? I received an interesting email from a reader last week, asking me whether an increase in his salary as a result of him possibly taking on a new role within his company was going to justify him applying for it – and accepting if offered the promotion. The new role, in his own words, whilst exciting, was going to involve longer hours and a lot more responsibility. He was just not sure if it was going to be worth it.

His issue was that his present salary was €32,000 and this was going to increase to €36,000 with the new job. And given that he now only pays tax at the standard rate of 20%, going above this amount and into a new higher tax threshold, which he would do at €36,000, he was going to be taxed at 41%. Someone had told him that half his salary would be going in taxes, so he was confused.

I was delighted he reached out looking for help with this because there can be a lot of confusion as to how much tax you think you pay and how much tax you actually pay.

The amount of tax you pay is normally expressed in either two ways – the standard rate of tax, which is 20%, and the marginal rate, which is 40%. Both of these terms are correct in that they show you the rate of tax paid on the last euro you earn.

Whenever I speak with people about their salaries, some tell me they are being taxed at 40%, so when you add on prsi and USC over 50% of their income is going on tax. This is what they believe is happening to their salary – but it’s actually not the case, and if you look at your average rate of tax, you’ll see why.

Average or actual rate of tax is calculated by dividing the total income tax you pay in a year by your taxable income.

It is actually really important to know the difference between your marginal rate of tax and what your actual rate of tax, is because your marginal rate doesn’t give you an absolutely accurate picture of how much tax you pay each year.

The gentleman who called me was under the impression that his €32,000 income was being taxed at 20% – but he wasn’t paying 20% on all of his income. His actual rate of tax, even after allowing for prsi contributions and USC rates and factoring in tax credits, pension contributions, mortgage interest relief etc, was only 9%. If he was to accept this new job and his salary was to increase, pushing him into the higher rate of tax of 40% (any income greater than €33,800 is taxed at 40%) then his actual rate of tax was only going to rise to 11%.

So, while part of his new salary was going to increase by 20% (standard rate of 20% to marginal rate of 40%) the new 40% rate was only being applied to €2,200 of his new salary and his actual rate of tax was only increasing from 9% to 11%, which I don’t think is a big jump.

What this meant in euros and cents to him was that his total tax bill for the year was going to increase by €1,341 in return for a €4,000 raise which was actually acceptable to him.

At least he now knew what this raise meant to him. And it was interesting to hear what he had to say when this was pointed out because his initial thoughts on the new role were strongly influenced by those who told him he’d be cripped by tax.

I was speaking with an accountant friend last week and a friend who works in a HR department of a medium-sized company here in Limerick and we were discussing this particular topic. And it was interesting to hear my HR friend say that many of the workforce at her company are clueless when it comes to how their salary is actually taxed, how much tax they think they are paying and how much they actually pay. They pay very little attention to their payslip and those that do, find it confusing. So, they have asked me to speak with their staff to give them some basics about how their tax is calculated, what standard cut-off points mean, what impact being jointly assessed with their partner can have on their net take home pay, how their tax credits should be apportioned, and so on. It is not that easy to understand, but we should all have at least a grasp of the basics.

My accountant friend thought that knowing what a person’s marginal rate of tax is was very important because it gave you an incentive to look at ways you can reduce the rate of tax you pay, particularly at the highest rate. Contributing to a pension, for example, is an excellent way of being able to reduce this and he showed me how a client of his was able to reduce the amount of tax he pays at the higher rate by exactly 50%. In other cases, people avoided paying tax at the top rate altogether, even though their income was above the standard 20% thresholds.

There are advantages to knowing what your, actual and marginal rates of tax are, and it is important to know the difference between both because if used together and understood, they will ultimately help you make better, more informed decisions about your money and earnings going forward.