There’s a lot of talk about tax rates, and at this time of year I thought it would be useful to review four basic concepts of Canadian income tax, to help you with your tax planning.
1. Tax-Free amount
The Tax-free amount is based on the basic personal tax exemption. This ranges in various provinces from a low of $9,160 in PEI to $12,069 in Quebec, Sask and Alberta. Ontario is in the middle, with no tax payable until you earn over $10,582.
2. Marginal vs. Average Tax Rates
Many people confuse their tax rate with their marginal tax rate. Your average tax rate is simply your total tax over your total income. Since Canada has a progressive tax system, higher income results in a higher tax rate. In contrast, the marginal tax is the amount of tax you would pay on your “next dollar” of income.
For example, let’s look at our Tax Rate Card to see the tax payable for a person earning $44,000:
As you can see, this person’s average tax rate is just 14.73%, but if they earn another dollar, that nex dollar will be taxed at their marginal tax rate of 24.15%. While average tax measures your tax burden, marginal tax impacts incentives to earn, save, invest or spend. Knowing your marginal tax rate can help you make effective decisions on taking on extra work, on how much to contribute to or withdraw from an RRSP. Your marginal tax rate also impacts your social benefits such as Old Age Security and Guaranteed Income Supplement.
3. Types of Income are taxed Differently
Interest income and earnings income are taxed at the same rate, in other words $100 from a part time job is taxed the same as $100 earned from a deposit at the bank. Dividend income includes any distribution of a company earnings to shareholders from stocks or mutual funds, and because the company has already paid tax on these earnings, dividends are given a tax credit for individuals, to avoid double taxation on the same money. Generally both interest and dividends are reported on a T3 or T5 tax slip. Capital Gains income is reported when you sell or are deemed to have disposed of a capital property, including stocks, mutual funds or real estate. While you may have paid tax all along on interest and dividends, you won’t have paid tax on increase in price per share (or unit) until you dispose of the asset (stock or mutual fund) and realize a capital gain. When you make a capital gains 50% of the gain is tax free and 50% is included on your taxable income and taxed at your marginal rate.
Taxation varies with your province and your marginal tax bracket, but for Ontarians earning between $47,631 and $77,313, the combined federal/provincial marginal tax rate on earnings and interest is 29.65%, on capital gains is 14.83% and on eligible dividends is 6.39%. These rates do not include extra tax credits you may be eligible for, such as tax credits for pension income, medical expenses, tuition fees, and charitable donations. You can look up 2019 marginal tax rates for various income levels and provinces here and other 2019 tax facts here,
4. RRSP vs. TFSA tax-sheltered savings plans
Both of these savings plans allow tax free growth, so that you do not pay tax on interest or dividends or capital gains within these plans. The difference is that the Registered Retirement Savings Plan (RRSP) provides tax credits at time of contribution and is taxable at time of withdrawal, while the Tax Free Savings Account (TFSA) provides no tax credits at time of contribution and is tax-free at time of withdrawal. Deciding whether you would benefit more from an RRSP or TFSA is best done when you can estimate your marginal tax rate both now and in the future. If your marginal tax rate is expected to be roughly the same now and in future, the TFSA is advisable. This is often the case either for low-income individuals or for those who are already retired or those who are expecting a high income during retirement from the sale of a business or a defined benefit pension. If your marginal tax rate is expected to be lower in your retirement than it is during your current working years, as it is for most people, then the RRSP is advisable.
We hope this review of four basic tax concepts will help you have confidence in how income tax impacts your financial planning. Please contact your Investment Advisor with any questions about your portfolios or your financial plans.
Elaine Kelly MBA CFP FCSI
Senior Investment Advisor, Manulife Securities Incorporated