There’s a first time for everything. Also to learn about taxes. The world of taxes is big, and it’s normal to have knowledge gaps. Especially if you’re getting started. This entry demystifies common tax misconceptions.
Tax misconceptions #1: The difference between average and marginal tax rate
This is not necessarily a misconception, but rather a lack of understanding. Average and marginal tax rate are not the same thing. You shouldn’t mix them.
The average tax rate
An average tax rate is simply taxes / taxable income. For example, if your income is CHF 100k and your average tax rate is 13.2%, then you owe CHF 13.2k in taxes. Tax authorities don’t normally set average tax rates directly. Instead, they define brackets for different marginal tax rates, or tax brackets. You can think of the average tax rate as the ‘end result’ after applying all relevant tax brackets to your taxable income.
The marginal tax rate
Marginal taxes are incremental tax paid on incremental income. The marginal tax rate is how much more taxes you pay on the incremental income percentage-wise. What does this mean? Let’s continue with the example above. Even if your average tax rate is 13.2%, your marginal tax rate might be 25%. This means that if you increase your income from 100k to 110k, you’ll pay additional 2.5k (0.25 * 10k) in taxes. Marginal tax rates normally increase as income increases. This results in progressive taxation. Progressive taxation means that high income earners have a higher average tax rate.
Linking average and marginal tax rates
Let’s look at a real example. The chart below contains actual data on the federal income tax rate in Switzerland. This is one of three levels of income tax as a Swiss tax payer. You can find out about others here.
According to the chart, your average tax rate is ~5% if your income is CHF 150k. This means you’ll be paying 7.5k in federal income taxes. Your marginal tax rate, however, is 11%. If your income increases by 20k to 170k, you’ll be paying 2.2k in additional taxes (0.11 * 20k).
In total, you’ll be paying 9.7k (7.5k + 2.2k) for a total income of 170k. Your average tax rate is 9.7/170 = ~5.7%. Now check the chart above for 170k. See the average tax rate? It’s 5.7%. This is not surprising. This is how you calculate the average tax rates for a given taxable income.
In a progressive tax system, the average tax rate (red line) will always be below the marginal (blue line). Why? Because the the average tax rate incorporates the lower marginal tax rates from lower incomes.
Tax misconceptions #2: “Watch out, you don’t want to hit a higher tax bracket – you could end up with less take-home pay”
This is a very common misconception. I’ve heard it many times To get it out the way: this is plainly wrong. You’ll never decrease your after-tax pay by increasing your gross income. This misconception is closely related to the difference between average and marginal tax rate we just talked about.
For the sake of simplicity, let’s use once again the chart above on Swiss federal income tax. Say someone has an income of CHF 103k. Their marginal tax rate is 6.6%. But it’ll increase to 8.8% if their income increases to CHF 105k. The mathematical fallacy would be to think that your taxes due would increase from 6.8k (103k * 6.6%) to 9.2k (105k * 8.8%), thereby reducing your take-home pay from 96.2k to 95.8k.
You should know by now that this is not the case. The marginal tax rate only applies to the incremental income above the higher tax bracket. In our example, the higher 8.8% rate only affects CHF 1.4k. Why? Because the new tax bracket kicks in only at 103.6k (see the chart). The impact of hitting a higher tax bracket is just CHF ~31 (1.4k * (8.8% – 6.6%)). Your after-tax income increases by ~1.8k (from ~99.9k to ~101.8k).
The only way for your after-tax pay to get smaller after an increase in gross income would be to hit a marginal tax bracket > 100%. I don’t know of any country implementing such a thing.
Tax misconceptions #3: “A tax deduction reduces the amount of taxes to be paid by the same amount”
Tax deduction is a buzzword in corporate coffee talks. Sometimes there’s misunderstanding around what deducting taxes actually means. This is especially true for those who are taxed at source.
The key to understand tax deductions is to realize that you don’t pay taxes on your income, but on your taxable income. In general terms, tax deductions are the bridge between the two:
Taxable income = total income – tax deductions
In most countries (including Switzerland), expenses required for you to perform your job can be deducted from your income. Typical deductions are commuting costs, mandatory social contributions (AHV, unemployment insurance), etc. There’s also many other types of tax deductions. The interest you pay on debt is another typical example.
Tax deductions bring down your taxable income. Put differently, they cause a negative increment in your taxable income. As explained in tax misconception #1, we use the marginal tax rate whenever we estimate taxes for incremental changes in income.
Let’s use once again the chart above on federal income taxes in Switzerland. Imagine that your taxable income is CHF 130k. You manage to get a CHF 20k tax deduction. What’s the impact on your tax burden? Well, because your marginal tax rate is 8.8%, you’ll pay 20k * 8.8% = CHF 1,760 less in income tax.
A tax deduction reduces the amount of taxes to be paid by the deduction times your marginal tax rate
The math might be a bit more complex if the tax deduction brings you down to another marginal tax bracket. You’d have to calculate your tax savings in two steps. But the concept is the same.
Tax misconceptions #4: “You’re better off with a mortgage because you can deduct it from your taxes”
This one is another classic. I’ve even heard that it makes sense to delay mortgage payments to harvest tax benefits. This will never be the case. It might make sense to delay mortgage payments for certain reasons such as opportunity cost of capital, access to cheap money etc. But taxes aren’t be one of those reasons.
When you have a mortgage, you pay monthly installments to your bank. Those installments cover two different thing. The principal and interests. The principal is the outstanding mortgage you still have to pay. When you pay for part of the principal, you reduce the amount of the original mortgage you owe. The interest is the cost of borrowing the outstanding debt. What’s the outstanding debt? The rest of the principal you still haven’t paid. If this is not clear to you, have a look at this video from Investopedia.
A mortgage deduction allows you to reduce your taxable income by the amount of money you’ve paid in mortgage interest over the year. There’s no tax saving whatsoever on the principal payments.
Mortgage interest deductions effectively reduce your interest payments. By how much? By your marginal tax rate. For example, assume that we paid 1,000 in interest over the year and our marginal tax rate is 30%. Because we paid 1,000 in interest, we can deduct 1,000 from our taxable income. At the marginal tax rate, it results in 300 less taxes paid. We can think of it as if we had only paid 700 in interest. That’s 30% less than the ‘real’ interests. But we’re still paying interests.
A mortgage interest deduction effectively reduces your interest payments by your marginal tax rate. You can only deduct the interest part. You can’t deduct principal payments.
Mortgages can be adequate under the right circumstances. With very low interest rates, not financing your house purchase may even be an inefficient use of your capital. Why? Because mortgages are normally the easiest way to get big loans. And big loans might be attractive if interest rates are low enough.
All in all, net-net you won’t be making any money off of a mortgage. You still are worse off by paying interests. With mortgage interest deductions, you just reduce the interest you pay.
Tax misconceptions #5: “You have to pay more wealth tax once you get a mortgage, because now you own a house”
From a wealth perspective, getting a house through a mortgage has 0 impact on your net worth. Your assets go up because now you own a house. But your liabilities go up as well because now you owe money. Remember that a mortgage is just debt after all. It balances out.
Tax misconceptions #6: “There are no taxes on shares/stocks/funds in Switzerland”
This statement is wrong because there’s not a single type of tax that affects your investments. There’s two. Capital gains taxes and income taxes.
Capital gains taxes
You pay capital gains on positive differences between the sale and the purchase of an asset. Imagine you bought a stock for $50. After a month, you sold it for $60. You have to pay capital gains taxes on the $10 profit.
In general, you should expect no capital gains taxes in Switzerland. There are some conditions for this, though. We went over these conditions in detail in this post.
Broadly speaking, you have nothing to fear if you’re a long term investor. The story is different if you trade in a more professional way (derivatives, intra-day trading etc.). If this is the case, the tax authorities might see your capital gains as income from self-employment. You don’t want this to happen. If it does, you’ll have to pay income taxes on your capital gains at your marginal tax rate.
Income taxes are taxes on dividends and interests. This means that dividends and interests are taxed at your marginal income tax rate. It doesn’t matter if your ETF distributes or accumulates dividends (as we saw here). You still have to pay income taxes.
In case you’re interested, this entry has additional info on how to optimize your ETF portfolio from a tax perspective.