Updated: Aug 26
Did you know that taxes can be one of your top 3 expenses? Think about it - depending on your marginal tax rate, you can be taxed between 20% to over 50% of your income. Taxes can seem scary and complicated and one of those rites of passage as an adult. Today, I will go over the basics of individual taxation in Canada.
Taxes have been around for ages and have been needed in society to fund for various social projects. There are a lot of different and strong opinions out there when it comes to taxes; however, today, I'm not going into any of that. Instead, I will be covering the basics of individual taxation here in Canada so you can better understand how the tax system works and ways to minimize your tax liability legally.
Canada taxes the individual based on a progressive tax rate based on your income level. This means that the more money you make, more taxes you need to pay. There are also two tax rates that will apply to you - the federal and the provincial/territorial rate.
For example, if you have a taxable income less than $49,020, you are in the lowest tax bracket of 15% for federal income tax purposes in 2021.. If you made more than that, but less than the $98,040, you still pay 15% on the first $49,020 and 20.5% on the next 49,020. And this continues as your income increases.
Let's not forget the provincial/territorial income taxes which have different tax brackets and tax rates. In the case of BC, if you have taxable income less than $42,184, you are in the lowest tax bracket for 2021 of 5.06%. If you made more than that, but less than the $84,369, you still pay 5.06%% on the first $42,184 and 7.70% on the next $42,184. You will notice that it may be easier to just look at the combined federal and provincial tax rate table.
You may notice that it's easier to just look at the combined federal and provincial tax rate table. Your marginal tax rate is determined by the top tax bracket that is applicable to you. It is relevant as the additional taxes you will pay for additional income that you earn. For example, if you earn $70k, your marginal tax rate is 28.20% (combined federal and BC tax rate), every $1,000 of additional income you earn, your tax liability can be estimated to be roughly $282. The marginal tax rate is different from the average tax rate, which is total tax paid divided by total income.
Your taxes are determined by your income earned during a calendar year, which is January to December, and due by April 30th of the following year. If you or your spouse are self-employed, then you have a bit more time to file as your tax returns are due by June 15th.
The difference between tax deductions and credits, is that tax deductions directly reduce income (above the line), which reduce your tax liability based on your marginal tax rate, whereas tax credit directly reduces your tax liability dollar for dollar
For example, if you have taxable income of $70k and have a $2k tax deduction, then it reduces your taxable income to $68k and decreases your tax liability by $564 (ie. $2000 x 28.2% marginal rate for combined federal and BC). However, if you have $2000 in tax credits, than it directly reduces your tax liability for $2000.
Tax credits can be refundable or non-refundable and varies by your eligibility. Non-refundable means it can reduce your tax liability to zero only, and any excess goes to waste. However, if you have refundable tax credits, it reduces your tax liability to zero and any excess is refundable, as the name suggests (such as the GST/HST credit or working income tax credit).
I will quickly go over the Income Tax and Benefit Return (also known as the T1) to show you applicable tax credits (personal tax credit, tuition credit, donations, medical expenses, interest on student loans, medical bills, FTHB)
Make sure you read until the very end on ways to earn additional income but being able to pay lower taxes - such as investment income and business income from side hustles
It's the type of income where you would pay the highest taxes since available tax deductions are very limited, so there aren't many ways to reduce your overall tax liability. The main tax deductions available for employees are pension plans, moving expense related to job relocation, childcare, disability, and education related expenses related to your employment.
One main way to reduce your tax liability is through RRSP contributions. You may be familiar with RRSP contribution due date which are 60 days after December 31st, in order to take the deduction for the previous tax year. RRSP contributions reduce your income dollar for dollar, and the tax liability reduced can be calculated based on your marginal tax rate.
Income through dividends and capital gains are given tax advantages. For example, capital gains are taxed at only 50%. Dividend income that you receive from Canadian companies often come with dividend tax credits.
For example, when you receive T5 Statement of Investment Income, there is a box for dividend tax credits which reduce your tax liability on the dividend income that you received. In Canada, integration is factored in where taxes paid by the corporation have been taken into consideration and passed on to you. In fact, if you were to completely live off eligible dividend income (and you have no other sources of income), you can actually receive up to $53,810 and pay no taxes. Fedral Alternative minimm Tax (AMT) only kicks in after you receive eligible dividends of $63,040, your tax liability will only be $1,385.
The Canadian income tax system is designed so that the combined corporate and individual taxes paid on income earned through a corporation and distributed to individual shareholders is equal to the income tax that would have been paid if the income had been earned directly by the individual.
Of course, there also other ways to earn tax-free investment income through a TFSA or a tax-deferred investment income through an RRSP. For more information, feel free to check out my post here explaining the differences.
Business Income & Expenses
If you are running a business, whether that is through a sole proprietorship, partnership or corporation, there is more "flexibility" in terms of deductions that can be taken. Basically, any reasonable business expenses incurred to produce business income can be deducted, which reduces your tax liability.
As a sole proprietor, there is no distinction between between the individual or the business, so you report all business income and expenses on your own individual tax return
For example, common expenses of running a business can be home office (ie. portion of your mortgage interest, electricity, utilities, internet, etc.), rent, vehicle related expense (ie. lease or depreciation, gas, parking, maintenance), phone bills, travel, meals and entertainment, as well as legal and accounting fees. These types expenses may already be a part of your normal expenses as an employee, but if you run a business and incur these expenses to incur business income, they can become deductible.
There are also other legal and tax planning aspects, as to whether operate your business as a sole proprietor or partnership or corporation but that is an entirely separate topic. If you are interested in a post explaining the difference between the various entities, let me know in the comment section down below.
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