Confused about the Stage 3 tax cuts? A financial expert breaks it down.

Ah, income tax. The bittersweet pill we all have to swallow each year. It's like that uninvited guest who shows up to the party and takes a big chunk of the snacks.

Regardless of your feelings about tax, you would have been hard pressed to miss rumblings about 'income tax' and 'Stage 3' popping up in your feed or on the news.

Plus this week, the government announced an overhaul of the Stage 3 tax cuts after it passed the Senate — the changes aiming to bolster the benefits for those on lower incomes.

So to keep you in the loop without putting you to sleep, here is a jargon-free guide that will have you up to speed in a flash.

Video: 4 money hacks that don't cut out your daily cup of coffee! Post continues below.

How does the tax system work?

You may already know that in Australia, you pay income tax based on a percentage of your pay, and this percentage depends on the income bracket your annual salary falls into.

What many people misunderstand, however, is that your entire pay isn't taxed on the one rate. Instead, your annual salary is broken up into segments and each segment is taxed at a different rate.

Let's take someone who earns $110,000. This puts them in the 32.5 per cent marginal tax bracket. The word 'marginal' here is key, because it means only their income between $45,001 and $110,000 is taxed at 32.5 per cent. The amount they earn between $18,201-$45,000 is taxed at 19 per cent, while the amount below $18,200 is tax free.

This means that rather than this person paying $35,750 in tax (32.5 per cent on their full salary) they pay $26,217 (also known as their average tax rate, in this case 23.8 per cent).

What do Stage 3 tax cuts do?

The latest tax cuts are a part of a seven-year plan to revamp Australia's personal income tax system in an attempt to reduce bracket creep. They were first introduced in the 2018 Federal Budget and are planned to be rolled out over three stages. Stage 1 took place on 1 July 2018. Stage 2 on 1 July 2020. And we are now entering Stage 3, due to come into effect on 1 July 2024.

What is 'bracket creep'?

Bracket creep means that the increase in tax you pay is outstripping the rate at which your salary is growing, and this is especially concerning when we factor in inflation (AKA increased cost of living).

Let's say, for example, you earn a salary of $50,000 and your boss offers you a 5 per cent pay rise to keep up with inflation. That puts your pay up to $52,500. Now, you would probably expect the amount of tax on your payslip to also go up by about 5 per cent. And this is where you would get a rude shock.

A 5 per cent increase in tax would take it up from $6,717 to $7,053. Instead, your income tax based on current rates jumps from $6,717 to $7,530.

In other words, your average income tax has increased by 12 per cent while your income has only increased by 5 per cent, despite the fact that you have remained in the same marginal tax bracket. In this instance, although your pay rise was 5 per cent, your take home pay only increased by 4 per cent.

Put it another way, a greater portion of your pay is gradually creeping out the office door as your income grows, and in some cases is leaving you worse off.

How much tax will I pay in 2024?

The original intention for Stage 3 was that there would be no changes to your take home pay if you earn up to $45,000, while those on incomes between $45,001 and $200,000 would receive a tax cut.

However, on January 25, 2024, the government announced a change of plans that would mean more people would receive a tax cut, including those earning under $45,000. The higher-income earners will still receive a tax cut, but it won't be as big as originally expected.

Now Australians earning less than $150,000 will get a larger return than was promised, and those earning more than $150,000 will still receive a tax cut but it will be less than originally planned.

Let's break it down below:

This means that if your taxable income is above $18,200, you can expect some extra change in your pocket with each pay starting from 1 July 2024.

How much you can expect will look something like this:

Now that the government's overhaul of the stage 3 tax cuts will become law soon, it's still wise to stay tuned for updates and be proactive about staying informed about any new developments. 

After all, being in the know is key to managing your finances effectively.

Natasha Janssens is a finance expert, author and founder of Women with Cents. You can follow her on Instagram.

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