April 2011

What’s hiding behind our income tax returns?

Behind the form we fill out each year is hidden a complex system of taxation where it’s easy to get lost... Welcome to “Income Tax 101,” courtesy of Actualis Express!

As the saying goes, in this world nothing is certain but death and taxes. The first is true beyond the shadow of a doubt; as for the second, well, that depends.

Let’s take a closer look.

Five factors to consider

Fundamentally, the amount of tax you pay on your income is based on five main factors:

  • the size of your income
     With social justice in mind, Canada favours a progressive taxation system whereby your tax rate increases with your income:  you not only pay more tax, you pay a larger percentage of your income.

  • the source of your income
    Your income is taxed differently depending on whether it comes from your salary or your investments:  wages and interest are subject to the biggest tax bite; dividends and capital gains are taxed at a lower rate.

  • your province
    Since tax rates differ from province to province, if you live in Alberta, for example, you’ll pay noticeably less tax than your brother-in-law in Manitoba on the same income.

  • your household situation
    Our system includes an impressive array of tax and social measures based on household income, number of children, services used, etc.

  • your tax planning
    You can reduce your total tax bill by using deductions, deferring certain kinds of income, allocating your investments wisely and splitting your income.

What not to do

These factors appear to be quite straightforward, but they are the source of both the complexity of our taxation system and the many errors made by taxpayers when filing their returns. Here are a few “don’ts” to watch out for:

  • Don’t confuse the marginal tax rate with the average rate
    It’s a popular misconception that we are all paying 50% of our income in personal taxes. This is because people confuse the marginal tax rate and the average rate. The marginal tax rate – which can in fact reach 50% in some provinces – is the tax that applies to each additional dollar that you earn above certain thresholds. At the federal level, for instance, these thresholds will be as follows for 2011:

    If your income is $75,000, your federal income tax will be calculated as follows: $0 on the first $10,527, $4,653 on the next portion, and $7,360 on the third portion. Total: $12,013, or 16% of your annual income. To find out the combined tax rates in effect in your province, we recommend using an online tax calculator such as the one provided by Ernst & Young.

    It’s important to understand these concepts not only to calculate your tax payable, but to help you make good decisions. Suppose you are thinking of taking a job that would increase your income from $75,000 to $85,000, but would force you to buy a second car. Well, if you live in Ontario, the car had better cost you less than $6,700 a year, because with a combined marginal tax rate of 32.98%, that’s how much of your raise you’d have left after the taxman got through with it.

  • Don’t forget your tax credits
    Every year, thousands of taxpayers – especially pensioners – pay more tax than they should because they aren’t fully aware of the tax credits and deductions they are entitled to. Even if you don’t have to pay any income tax, you can still claim certain credits. Tax credits known as “refundable” are not simply “deductions”:  you are entitled to them based on your income, no matter what.

    On the other hand, don’t forget about all the credits and exemptions that may be lost with a move into a higher income bracket. Some studies show that these lost benefits could have the effect of a spectacular increase in the marginal tax rate – to the extent that the middle class would be burdened with the highest marginal rates, instead of the wealthiest taxpayers. Here’s some advice:  know your tax credits.

  • Don’t fail to manage your sources of income strategically
    Another frequent mistake:  managing your investments without paying attention to the different tax rates that apply to interest, dividends and capital gains. Your financial services professional can help you distribute your investments with a view to ensuring that your most heavily taxed investment income is tax sheltered.

  • Don’t neglect to file an income tax return
    Suppose you take a sabbatical and your income for the year is less than the basic exemption. You should still file a tax return in order to create RRSP contribution room that you will be able to use to decrease your taxes in future years.

    These are just a few of the many pitfalls that await the unwary taxpayer… And that’s why you shouldn’t look at income taxes as an annual April headache:  instead, they should be a topic of regular discussion with your accountant and your financial services professional.

    After all, if you feel as if you’re paying too much income tax, remember this fact:  you could be right!