Busting three common tax myths
I often hear discussions of taxes that are misleading or just plain wrong. In some cases, being wrong won’t hurt you. However, there are times when believing one of these tax myths could cost you financially.
Most of these myths are related to tax withholding from employee paychecks. This system lessens the administrative burden for taxpayers, but also decreases your awareness of how much you’re actually paying in taxes.
Let’s examine three common tax myths to find out where they originated and what the truth is.
“My refund is higher this year, so I paid less in taxes”
Many people don’t know that a refund or amount owed is just a small part of your annual tax bill. Most of your tax bill is paid by your employer on your behalf via withholdings from your paychecks.
When you complete your tax return, you are comparing your total tax (which is calculated from your income) against the tax payments withheld by your employer. If your withholding is more than your total tax, you will get a refund. If your withholding is less than your total tax, you will have to pay the difference before April 15th.
This is a simplified version of the equation used by the IRS to calculate your refund or amount owned each year.
For example, if your employer withheld $8,000 in taxes, but your total tax is only $6,000, you will receive a $2,000 refund. If your total tax was $9,000, you would have to pay an additional $1,000.
8,000 – 6,000 = 2,000 refund
8,000 – 9,000 = -1,000 owed
If your refund is higher than last year, it could mean you had a smaller total tax (i.e. “paid less in taxes”) or it could mean your employer withheld more than they did last year. To find out for sure, you’ll need to look at Form 1040, which is your tax return document.
Line 16 is your tax, gross of credits
Line 24 is your tax, net of credits. This is what you actually paid in federal income tax.
Line 25d is your tax withheld from paychecks
Comparing these lines year after year will tell you if you’re actually paying more in taxes, or if your employer is withholding less (which means bigger paychecks!)
Are refunds good? What is an underpayment penalty?
When you receive a refund, it means you overpaid your tax bill; essentially, you gave an interest-free loan to the IRS. It’s not always a bad thing to do, but if your refund is excessive every single year, you might consider adjusting your withholdings to make your paychecks larger.
And if you are consistently having to pay more tax at filing time, you may be incurring an underpayment penalty. Usually if you owe less than $1,000 at tax time, you won’t be penalized. Once the amount due exceeds $1,000, you may be subject to a penalty. You will find your penalty amount on Form 1040 Line 38.
If you are not happy with your refund (or amount owed), it may be a good idea to complete a new Form W-4. This form tells your HR department how much you want withheld from each paycheck.
“Overtime is taxed more than regular income”
This has been a hot topic recently, as two candidates on the 2024 Nebraska ballot – Dan Osborn and Donald Trump – ran on cutting taxes on overtime pay.
To be clear, overtime wages are taxed just the same as any other wages. Don’t believe me? Look at your Form W-2 (provided by your employer in January) or your Form 1040 (created by your tax preparer) and you will not see any line or box labelled for “overtime” wages; all you see is “wages, tips, or other compensation” (which includes overtime pay) on Line 1 of both documents.
Still, anyone who’s worked overtime (or received a bonus) knows the deflating feeling of seeing your extra pay seemingly evaporate into tax withholdings. So, if overtime is taxed the same as regular income, where does this myth come from?
Recall the United States has a progressive tax system, meaning the first few thousand dollars of income is taxed at a lower amount than the next few thousand dollars. When your employer withholds taxes from your normal paycheck, they withhold based on the average of all tax brackets, known as the effective tax rate.
Example:
Let me use an example of a Steve, a Single taxpayer who earns $65,000 using 2025 tax brackets:
The first $15,000 of income will be taxed at 0% (the standard deduction)
The next $11,925 of income will be taxed at 10%, or $1,193 total tax.
The next $36,550 of income will be taxed at 12%, or $4,386 total tax
The final $1,525 of income will be taxed at 22%, or $336 total tax. Also, any additional income (up to $54,875) will be taxed at this rate.
Add it up, and Steve will owe $5,915 federal income tax on his $65,000 in income. When you divide that number into his 26 paychecks, it amounts to $228 withheld from each $2,500 gross paycheck, for an effective tax rate of 9%.
What happens when Steve earns $1,000 overtime pay in a pay period? His employer will withhold additional taxes from that paycheck. And since Steve has already filled up his lower tax brackets, the entire $1,000 of overtime will be taxed at 22%; this is known as his marginal tax rate. His employer knows this, so they will (correctly) withhold $220 from his paycheck for federal tax. Steve’s gross pay was 40% higher, but his tax withholding was 96% higher, and that is why it seems like overtime is taxed more.
The two different ways to express tax rates:
Effective tax rate = Total Tax ÷ Total Income | This tells you what percentage of your income was paid to the IRS.
Marginal tax rate = The tax rate on the next dollar of income. This is what financial planners use to calculate the tax impact of a raise, a bonus, or overtime pay. This is often (but not always) the same number as your “tax bracket”.
By the way, Steve would pay the same amount in taxes if he received $1,000 as an annual raise instead of overtime pay. But since the additional taxes would be spread over 26 paychecks, the increased withholdings are less noticeable. And speaking of raises…
“A raise will put me in a new tax bracket so I’ll end up with less money”
The tax bracket you are in only determines the tax you pay on additional money; this is your marginal tax rate. Think of your income like pouring water into a series of buckets, each with their own tax rate. Your buckets are filled smallest to largest, and the tax rate in each bucket only applies to the water (income) in that bucket.
These “buckets” represent the progressive nature of the Federal income tax system. When you receive additional income, it is taxed at the higher amount, but the already existing dollars are still taxed at the lower rates.
I’ve (crudely) illustrated the example of Steve from above. When Steve receives his $1,000 in overtime pay, it will continue to fill the 22% bucket, and the income that is already in the smaller buckets remains unchanged.
This myth is perhaps the most damaging of all, as people may pass up opportunities for career advancement for fear of ending up with less money in their pockets. To be clear, you will never make less money by earning more money.
However, it is true that the more money you make, the less you get to keep from the next dollar you earn, which can affect decision making when work becomes optional. I was recently working with a client who is approaching retirement. She didn’t need to work in retirement, but she was considering a part-time job to earn a little extra money. I told her after FICA tax, Federal and state income tax, and the “social security tax torpedo,” she would pay over 30% in taxes on the money from her part-time job. When we did the math on what she would get to keep after an 8-hour workday, she decided not to take the job.
If you have questions about your tax situation, please contact us using the link below.
About the Author
Joseph Fowler, CFP® is a financial planner and co-owner of 402 Financial in Lincoln, NE.
402 Financial provides financial planning and investment management services to people approaching or in retirement. Joe always acts as a fiduciary and never takes commissions on product sales.
Click this link to schedule a free consultation with Joe.
