A Simplified Explanation of the Canadian Income Tax System

You’ve made it through another tax season!  You probably made it through alive and hopefully came out a little richer (or possibly a little poorer if you had to pay the CRA).

Those beginning months of the year leading up to tax season can be very stressful.  Most just want to get through it and have it done with.  This may be why many of us don’t really know much about our taxes.

I’ve always found that you stress and fear the things you do not understand.  That is why I went to school for finance; I didn’t want to be fearful of money for the rest of my life so I set out to learn as much as I could about it.  In this post, I would like to try and alleviate some of the fears or unknowns you may have about the Canadian tax system so you can prepare your tax return with confidence and hopefully a little more money in your pocket.

Tax is a problem none of us can avoid, unless you do not have an income (then you have other problems on your hands).  Even though taxes are something every Canadian faces, many of us are still unsure how taxes are calculated or why we end up paying the government or receive a tax refund.

I thought I would give a fairly quick and simple outline of how taxes are calculated here in Canada.  I will explain how different income levels are taxed differently and provide ways in which you can reduce your taxes each year.

Since taxes do vary province-to-province (or territory), I will focus only on Ontario tax amounts.  You will be able to use the basic concepts I discuss in this post and apply them to your own province’s tax rates.

The first thing I would like to talk about is the progressive tax system.

 

Progressive Tax

The basic idea behind a progressive tax system, like we have here in Canada, is that the more money you make, the more you pay in taxes.  Actually, the correct definition would be the more money you make, the more you pay in taxes exponentially.

If we had a flat tax rate, a person who made more money would still pay more taxes.  As an example, say the tax rate was a flat 10%.  A person who makes $40,000 would pay $4,000 and a person who makes $100,000 would pay $10,000.  The higher earner pays more in taxes.

But in a progressive tax system, the rates change as the income increases.  As a simple example, let’s say that for income under $50,000, you pay a 10% tax and for income of $50,000 or greater you pay 20% in taxes.  Therefore, a person making $40,000 would pay $4,000 in taxes while a person who earns $100,000 would pay $20,000.

There is one big difference in the Canadian tax system though.  In our progressive system, everyone pays the same amount of tax up to the limit for the first tax bracket.  Then, any money earned over that amount is taxed at the next rate until that tax bracket limit, and so on.  I know, that’s a little confusing.  I think an example might serve us better.

Let’s make a simple progressive tax system that has 2 tax brackets.  The first applies to income of $0 – $50,000 and has a rate of 10%.  The next bracket is income greater than $50,000 and has a rate of 20%.  Now let’s look at our two earners again (the $40,000 and $100,000).

  • Earnings = $40,000
    • Tax = $40,000 x 10% = $4,000

This is no different than the previous example.

  • Earnings = $100,000
    • Tax
      = ( $50,000 x 10% ) + ( $50,000 x 20% )
      = $5,000 + $10,000
      = $15,000

This amount is different than the $20,000 calculated before.  This is because the first $50,000 was taxed at the 10% rate.  This is a very simple version of how our tax system works at both the Federal and Provincial levels.

This is what many people misunderstand when talking about the Canadian tax system.  They think that when they move into a new tax bracket that they will be charged a higher tax rate on the whole amount.  This is not true.  The first tax bracket amount is charged the same to everyone from a person making $20,000 to a person earning $300,000 a year.

It is the money above each tax bracket that gets charged a higher rate.

 

Canadian Rates

Now that we understand how a progressive tax system works, let’s look at the rates in Canada.

If you go to the CRA website, you will be able to find the current tax rates for Canadians.

For the 2012 tax season, the rates are as follows:

  • Federal Tax Rates:
    • 15%        on           $0 – $42,707
    • 22%        on           $42,708 – $85,414
    • 26%        on           $85,415 – $132,406
    • 29%        on           $132,406 and over
  • Provincial Tax Rates (Ontario):
    • 5.05%    on           $0 – 39,020
    • 9.15%    on           $39,021 – $78,043
    • 11.16%  on           $78,044 and over

You can find the other provincial (and territory) rates at the CRA website as well.

Now that we have the real Canadian tax rates, let’s look at our example again and find the taxes paid by our two earners.

  • Earnings = $40,000
    • Fed Tax = 40000 x 15% = 6000
    • Provincial Tax
      = (40000 x 5.05%) + (980 x 9.15%)
      = 2020 + 89.67
      = 2109.67
    • Total Tax = $8,109.67
    • Tax Rate = 8109.67 / 40000 = 20.27%
  • Earnings = $100,000
    • Fed Tax
      = (42707 x 15%) + (42707 x 22%) +(14586 x 26%)
      = 6406.05 + 9395.54 + 3792.36
      =19593.95
    • Provincial Tax
      = (39020 x 5.05%) + (39023 x 9.15%) + (21957 x 11.16%)
      = 1970.51 + 3570.60 + 2450.40
      = 7991.51
    • Total Tax = $27,585.46
    • Tax Rate = 27585.46 / 100000 = 27.59%

As you can see, the higher income earner not only pays more in taxes ($27,585.46 > $8,109.67), but they also pay a higher tax rate (27.59% > 20.27%), more than a 7% difference.

It’s easy to see how taxes become so confusing.  It is only simple math, but it is a lot of simple math that must be followed in a certain way.

Does this mean that everyone earning $100,000 will have a tax rate of 27.59%?  The answer is no.  This is because there are ways in which you can reduce your taxable income in a year.  A person earning $100,000 a year could effectively cut their tax rate down to the same level as someone earning $40,000 or even less.

In the next section, I will show you some popular and efficient ways to reduce your tax rate if you are in the medium to high tax brackets.

Note: If you are in a low tax bracket, these methods will help you as well.  The effect will just be less dramatic.  Individuals try and achieve the lowest tax rate possible; if you are already in the lowest tax bracket, there isn’t another tax bracket to move down to (although you can reduce your dollar amount paid in taxes).

 

Tax Breaks

#1. Changing the type of income you receive.

This is a method many wealthy individuals use to reduce the amount of taxes they pay.  The idea behind this method is that not all income is taxed equally.

There are basically 4 types of income an individual can earn (all outside of a business; corporate tax strategies will not be discussed in this post):

  • Salary or Earnings
  • Interest Income
  • Dividend Income
  • Capital Gains

The first two sources (salary and interest income) are taxed fully.  This means that every dollar earned is taxed.

The second two sources (dividend and capital gains) are where large tax savings can be made.

Dividend income is generated from investments such as preferred stock or common stock (equities).  This is money that is paid out to shareholders of corporations.  The reason why this income is taxed at a lesser rate is because the corporation has already paid tax on these monies and it gives people the incentive to invest in corporations (or in the economy).

In Canada, the corporation must be an approved Canadian company by the CRA.

The way this income is taxed is quite confusing.  It involves marking up the income by a certain percentage.  This makes for a taxable amount greater than the actual income, but then a dividend tax discount is applied to taxable income afterwards.  It is a confusing system, but it does lead to lesser taxes than through salary or interest income.

Capital gains occur when you sell an asset for greater than you paid for it.  This could be a stock, a bond, a house, and many other types of assets.  For example, say you had a stock that cost you $10 and you sold that stock in the same year for $20.  You have effectively made a $10 (20 – 10) capital gain.

In Canada, only 50% of your capital gains are taxed.  That’s a huge tax cut!  This means that if you made $100,000 in capital gains, you would only be taxed as if you earned $50,000.  That means a lot more money in your pocket.

#2. RRSPs

RRSP stands for registered retirement savings plan.  The purpose of this plan is to save money now for your future retirement.

To persuade Canadians to invest for their retirement, RRSPs offer a tax incentive.

RRSPs allow you to defer tax to your retirement years.  It also allows for interest, dividends, and capital gains to build without being taxed (until retirement or when you redeem the funds in the account).

This is a great account to build wealth because it lets compounding work to its fullest potential.  Any money deposited into the account is pre-tax money and any money gained in the account all goes towards future returns.

There is a catch though with RRSPs.  They are not the best vehicle for savings in every case.  The money in the account will be taxed one day.  The most efficient use of an RRSP is to save when you are making the most money in your career and redeem the money when you expect you will be in a lower tax bracket.

I won’t elaborate too much on best uses for an RRSP because I am going to be explaining it more thoroughly in another post.

What is important to know is how RRSPs affect your taxes now.

If you are in a medium to high tax bracket and you have a significant amount of savings, an RRSP can help bump your total taxes paid and tax rate down.  This is because any money that is deposited into an RRSP is not taxed.

As an example, say you earned $100,000 as a salary this year (meaning you are in a high tax bracket).  Say you are able to –and want to- save $16,000 for retirement in an RRSP.  This means that instead of a tax base $100,000 for the year, you would have an effective tax base of $84,000 (100,000 – 16,000).

By doing this, you have successfully knocked yourself down a tax bracket.  Initially, the last portion of you income was taxed at 26% federally, but after investing in your RRSP, the last portion of your income is now taxed at 22%.  4% (26% – 22%) is a significant amount.  That’s more than average inflation!

An RRSP can be a great vehicle for tax saving when used in the right way, in the right amounts, and at the right time in your life.

#3. Have a Kid

This is not for everyone, but if you have a child, there are some tax advantages that come with that little bundle of joy.

If your kid(s) are under the age of 6, you could be claiming child care expenses to help reduce the taxes you pay.  These expenses could be for a nanny, day care, or other child care related service.

There are two important notes that must be disclosed though.  If you are paying your nanny under the table and they are not claiming the income for their taxes, then you are not eligible for the tax break.  Also, the tax break is usually applied to the lower income earner in the family.

Another available tax deduction regarding children is the physical fitness and arts activities for children tax break.

These include fees for sport programs and art programs your child may be enrolled in.  Have a kid in soccer or hockey?  Is your youngest son learning to play the piano or guitar?  Well, you can take those expenses and deduct them from your income to lower your tax base!

There are some rules though.  The program must be 8 consecutive weeks long or 5 consecutive days.  And the bulk of the program must include the arts or fitness. The program must also be supervised and appropriate for children.  But luckily, most of the programs you enroll your child into will meet these requirements.

#4. Get Married.

Again, this isn’t for everyone.  But there are benefits to being in a committed relationship that is recognized by the government.

One advantage is a spousal RRSP.  This allows the main breadwinner to contribute to a spouse RRSP and reduce their income base for tax purposes.  It also allows for more contribution room towards an RRSP account per year.

Another advantage is income splitting.  There have been some changes in the past few years regarding income splitting that has restricted many forms of income spitting, but there are still opportunities.

If you own a business, you can hire your spouse (and children) onto payroll and split up the income.  I’ll explain this through an example.  Say you earn $100,000 through your business.  If you were to claim the whole amount to yourself, then your last dollars of income would be charged at a rate of 26% federally.

Now say you had a spouse and two kids.  If you add them onto the payroll and have them work for the company, then you can greatly reduce the amount of taxes paid.  Your family still takes in the $100,000 of income, but now it can be split among the members.  Maybe now you take in $40,000, your spouse takes in $30,000, and each of your kids take in $15,000 for the year.

By using this method, you have successfully dropped your last dollar of income from the 26% bracket all the way down to the 15% bracket.  Not too bad!

But this method does require you to own your own business.

#5. Donate to a Charity

Many of us enjoy giving back when we can.  Donating your money to a charity you believe and trust in can be very fulfilling.

The Canadian government has tax deductions specifically made for donations made to eligible charities.

One great thing about this deduction is that it can be carried forward.  That means that if you find an old charity receipt in the closet, you can still apply it to future income tax years.

Another tip is to bundle your charitable tax receipts and use them on the family member that has the highest income tax base.

 

These are just some of the many ways you can save on your taxes.  I’ve missed many such as moving expenses, university tuition, medical expenses, child support payments, and a long list of others.

I suggest grabbing a book that gives tax tips and explains tax deductions.  Look through the table of contents and jump to sections that look like they apply to you.

There are also some great websites that give you information on taxes.  One of the best is the Canada Revenue Agency (CRA); yup, that’s who you pay your taxes to.  They give clear information on all the different tax deductions and when they can be used.  Another website that has quick and simple guides to taxes is “Canadian Tax Resource”.  It’s a blog that covers many different aspects of Canadian taxes.

I hope this post has helped you understand how the Canadian tax system works and I hope it has got you thinking about effective ways to save on your taxes.

Remember that no one person can know everything to do about their taxes.  It might serve you well to talk to a professional accountant or tax preparer to find out how you can save more on your taxes.  It may cost a little to get that advice, but in most cases you will recoup those costs and get a little extra through the tax saving advice they provide.

Thanks for reading and good luck out there!

Do you have anything to add?  What ways do you save on taxes?  Comment below and share with us your comments or stories!

 

Warning/Disclosure: This article is for educational purposes.  Tax fraud is a serious and punishable offense.  Make sure you meet the requirements necessary for each type deduction.  Always prepare taxes in a legal matter and lean towards conservative tax practices.  It is wise to consult professional advice regarding your taxes to make sure you abide by the rules of the CRA.

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