Last fall, changes were made to the FLSAs Overtime Rules, raising the incomes for those considered non-exempt salaried employees.  Basically, unless you make a certain amount, your employer must pay you an hourly wage AND overtime pay for anything over 40 hours a week.  As someone who routinely worked 50-60 hours a week on salary the last few years, the opportunity to now earn overtime has put a new spring in my step.


There’s a lot of misguided information out there – I read through most of it while researching this article.  Now, I’m in no way a tax expert or a financial planner, but I will tell you that there are tons of resources on the Internet for learning about all things tax related.  The main point of this article is to show an example of how, in certain cases, I think working overtime (if you have the opportunity) is one of the most efficient ways to increase income, which won’t all go to higher taxes.

Tax Rates

There are two different tax rates – Marginal Tax Rates and Effective Tax Rates.

  • Marginal Tax Rates are your tax brackets (10%, 15%, 25%, etc).  Marginal Tax Rates do NOT apply to all your income, just portions of your income.  Here’s the 2016 Federal Tax Brackets for Single Filers (which we will use for our example) below:
Rate Single Filers
10% $0 to $9,275
15% $9,275 to $37,650
25% $37,650 to $91,150
28% $91,150 to $190,150
33% $190,150 to $413,350
35% $413,350 to $415,050
39.6% $415,050+
  • Effective Tax Rates are the Total Federal Tax you pay.  Your effective tax rate is the average rate at which your income is taxed.  This includes deductions and exemptions, as well as credits.  For example, someone making $37,650 a year who only takes the standard deduction and claims 1 exemption (no 401k contributions, no tax credits, etc.) has an effective tax rate of around 10%.

You need to know what your Tax Liability is.  When you file taxes for the previous year, your effective tax rate is calculated as the percentage of Federal Income Tax you should have paid based on your income.  If you paid more than your tax liability, you get a refund.  If you paid less, you owe the government money.

Example: 5 Hours A Week

Here’s an example of how much extra money someone (lets call him Alan) could earn working an extra 5 hours a week of overtime.


Assumptions
  • Alan is filing as a single filer and claiming 1 exemption (himself) and the standard deduction.  This reduces his taxable income by $10,350.
  • In order to illustrate that despite moving into a higher tax bracket because of overtime, we’ll say Alan makes $48,000 a year.  This means after subtracting the $10,350 above, his taxable income is $37,650.  If you refer to the chart above, you’ll see that any extra dollar Alan earns will be taxed in the 25% tax bracket.
  • Alan gets paid every 2 weeks.
  • For simplicity I’ve ignored state taxes.
  • FICA is 7.65%.

Working 40 hours a week, Alan makes $48,000 a year, or $23.07/hour pre-tax.

After taxes (Federal and FICA), Alan’s hourly wage drops to $19.86/hour.

He has an Effective Tax Rate of 12.91%.  (This is the actual amount of tax he is liable for.  Remember, effective tax rate an average of your marginal tax rates.)

If Alan works 45 hours a week, he’ll get 5 hours of overtime.  His pre-tax overtime pay is $34.60/hour (he gets time and a half for overtime).  So each week he earns an extra $173.02.  Since all of this is in the 25% tax bracket, he’ll have 32.65% of that pay withheld for taxes (25% Federal + 7.65% FICA).

This is the part that gets confusing.  Just because Alan has almost 33% of his overtime earnings withheld for taxes doesn’t mean he loses that money.  In an effort to take the right amount out of Alan’s paycheck his employer will tax his income at his highest marginal tax rate, making it seem like he’s paying more in taxes due to earning more.  The reality is that while Alan is having a higher percentage of money taken out of his paycheck, his tax liability will only increase a little bit.  He will get a portion of that 33% back at tax time, either as an addition to his refund or a reduction in the amount he owes.

By working 5 hours a week of overtime Alan earns an extra $8652 a year pre-tax (weekly pay of $173.02 x 50 weeks (he’s hopefully not working overtime on his two weeks of vacation!) = $8652).

Adding that to Alan’s existing salary brings his pre-tax annual income to $56,638.  His Effective Tax Rate increases from 12.91% to 14.75%, or a little over 20.5% and 22.25% respectively if you include FICA.

Since his effective tax rate is used to figure the tax liability on ALL his income, we apply that tax rate to his overtime income and get a Real Overtime Wage of $27.48/hour after tax.

So on payday Alan is seeing a $5/hour difference between what he thinks he’s earning and what he’s actually earning.

Broken down into percentages, Alan’s scenario looks like this:

Dollars (post-tax) % Increase – post-tax
Hours Worked 12.5%
Paycheck Extra +$114.18 15%
Actual Extra Earned +$134.26 17.5%

Summary

In short, by increasing his hours worked by 12.5%, Alan earned almost 18% more income, although on his weekly paychecks it only felt like 15% more money.  Since all of this extra income was in a higher tax bracket, Alan’s taxes also increased.  Whether you look at it from a weekly basis or at the end of the year, it’s clear that the gains Alan made in income:

  • surpassed the percentage increase in # of hours worked
  • surpassed the amount his effective tax rate increased
  • By not adjusting his withholdings, Alan will get over $1000 as a tax refund next year.  He paid too much in taxes!  (His effective Federal Tax Rates were 10.8% without OT and 13% with OT).
    • I can’t help but mention that contributions to a pre-tax retirement account do a lot to lower your effective tax rate.  The contributions reduce the amount of income that could be taxed at your highest bracket, lowering your effective rate.

The Bottom Line

The numbers above are just an example and I tried to be as simple as I could be.  Obviously there’s a lot of variables that go into each person’s taxes and every situation is different.  But after finding searching for a more balanced discussion on why you SHOULD opt for overtime all I could find was a reddit thread with a few comments.  I couldn’t find a detailed breakdown with numbers and examples.  I did find a lot of people who were convinced that working overtime is NOT worth it because they paid more in taxes.  While this is technically true, your hourly wage is still higher than your regular wage even with the slightly higher taxes.

Also remember that the average annual income per person in the U.S. is around $27,000 a year – which is towards the bottom of the 15% bracket after deductions and exemptions.  We ran these numbers with an increase from 15 to 25%, so keep in mind that working overtime could be even MORE effective if your income tops out at one of the lower tax brackets.


But anyways, the real point is this:

If you want to earn more income and are willing to spare more time, taking advantage of overtime opportunities at your current employer might be more effective than side hustles, part time jobs, etc.

When it comes to living below your means, you can either increase income, trim expenses, or both.  The number one way to increase income seems to be switching jobs.  And there are a lot of folks who make good money with side hustles.  But ignoring overtime opportunities at your day job because you think the extra money “all gets eaten up by taxes” could be shortsighted.

Instead, think about the ways it’s more convenient to work more at your current job (already there, more of the same work, easier to schedule) vs. pursuing a side hustle or getting a part time job (additional commuting, additional schedule, likely lower pay for time).  I personally think side hustles are great and can be a lot of fun.  I’m just saying it’s important to consider all your options.

I also get that there’s the issue of burnout, especially in a time where employees are always connected to work and many already work more than 40 hours a week on a regular basis.  Working 80 hours a week and being miserable just to save more money isn’t the goal here.  The example above was intended to show that a few extra hours a week can have a big impact, just like how a few dollars a day adds up over a year or how walking an extra mile or two a day can drastically improve your health.

For those of you who want to run the numbers yourself, I recommend this calculator from SmartAsset.com – it’s what I used to do most of the calculations for this post.

Image by Sira Anamwong at FreeDigitalPhotos.net