How income tax works

Every year there is a ritual we all follow where we visit a familiar face we have nearly forgotten and like clockwork, around the same time, we find ourselves in the same situation. That’s right, it’s tax season and we either put our own accounting hat on or we go see that familiar face who punches a few numbers in a computer and tells you whether you owe money to the government or you’ll be getting a nice cheque in the mail.

A fundamental concept that impacts our day to day life and a lot of people have a hard time understanding how taxes work. They notice some tax deductions on their pay stub and then receive some paperwork in the mail from investment firms and their employer such as T4’s and they give it to the accountant.

Let me break down the basics of income tax in it’s simplest form for you. The bottom line is this; The government wants to know how much money you made between January 1st and December 31st of that year and then in return, they will tell you how much of that money you owe them. There is an important lesson to be found here about finances and that is to look at it from a long-term perspective. Don’t focus on the paycheque to paycheque, look at it from a macro lens, look at it from a yearly perspective but I digress, let’s move on.

Types of income

Your total income can be from a single source such as your employer or you may have multiple sources of income such as capital gains from sales of an asset, dividends, revenue property and the government wants to know all about it.

Sure, there are some types that don’t need to be claimed such as lottery winnings or gifts – Head on over to the Canadian Revenu Agency website to see what they consider exempt.

Deductions you say?

That’s right, you can reduce your total income. You see, there is an understanding that sometimes to make money it costs money and the government gets that. You are allowed to claim certain items for that year as a deduction to your overall income. Deductions such as the interest paid on a student loan or child care expenses for example. You can find a whole list of eligible deductions on this section of the Canadian Revenue Agencies website.

Notice that I said deductions incurred for that year, that is between January 1st and December 31st. Sorry, you can’t turn back time … or can you? That’s right, RRSP’s. This is the only investment vehicle that I know of that can be made in a new year and applied for the previous year, as long as it’s done within the first 60 days – it explains why we keep hearing all those RRSP commercials in January and February.

But I only see my accountant in March, that’s passed the deadline

It is true that by the time we get all our documents in order and go see our accountant the RRSP deadline has passed but there are a few things you can do to help estimate your situation.

So my employer has been deducting taxes, is that a deduction?

Not quite, that is what is called withholding tax. You see, the government knows that we are not fiscally responsible. If we got paid our full paycheck (also known as the gross pay) and got slapped with a tax bill at the end of the year there is noooooo wayyy they would see that money. So instead, they provided a fancy formula to your employer that a certain percentage of your paycheque would be deducted every time and the employer would pay your taxes on your behalf

In that case, why doesn’t my employer take the proper tax and be done with it?

Well you see, everyone’s situation is different and your employer can only provide an estimate based on your salary and the employment situation. For example, you may have special deductions or a second job that the employer knows nothing about

So how are taxes calculated?

As it was mentioned earlier, the government only cares about your total income minus the deductions. So let’s use an example to help calculate the income tax one would have to pay.

Meet Simon. Simon lives in British Columbia and in 2017 he made a salary of 150,000$. His employer withheld taxes in the amount of 20,000$ for the federal government and 15,000$ for the provincial government. Simon also contributed 10,000$ in his RRSP.

Simon

Province: British Columbia

Salary: 150,000$

Federal withheld tax: 25,000$

Provincial withheld tax: 15,000$

RRSP Contribution: 10,000$

As you can see, there are two income taxes that must be paid, a federal income tax and a provincial income.

Now, as far as the government is concerned, Simon has a reported income of 140,000$ (150,000$ – 10,000$) and that is what they will tax him on.

Canada uses a progressive tax system and what that means is as you make more money a portion of that income is taxed at a different rate so it’s not as simple as calculating a single rate on the total amount.

Let’s start off by calculating the federal Income tax. If we head on over to the Canadian income tax rate section of the CRA website for 2017 it mentions that;

1. The first 45,916$ of your income is taxed at 15%
2. The next 45,915$ of your income is taxed at 20.5%
3. The next 50,522$ of your income is taxed at 26%
4. The next 60,447$ of your income is taxed at 29%
5. The remaining income after that is taxed at 33%

In our situation, Simon has 140,000$ of declared income so we are only concerned with the three first points.

Let’s get started,

45,916 x 15% = 6,887.40$ in taxes owed.

Now because Simon made 140,000$, we take his income and deduct it by the amount we just finished calculating (after all, we don’t want Simon to be paying taxes on this amount again at the higher rate).

140,000 – 45,916 = 94,084$ income remaining to be taxed on

So, now we know that the next tax bracket is for 45,915$ at 20.5%

45,915 x 20.5% = 9,412.58$ in taxes owed for this bracket

Alright, we’re almost there. Let’s deduct this income we just taxed from the remaining income he had left;

94,084 – 45,915 = 48,169$ income remaining to be taxed on

Finally, the next tax bracket is for 50,522$ at 26% but Simon only has 48,169$ income left to pay taxes on. In that case, we should only use Simon’s remaining income to calculate the remaining taxes he must pay.

48,169$ x 26% = 12,523.94$ in taxes owed for this bracket.

So what does this all mean for Simon? We simply sum up those three numbers to get the total federal income tax that Simon owes’

6,887.40$ + 9,412.58$ + 12,523.94$ = 28,823.92$

Canada uses a progressive tax system