February is tax preparation time! Time to collect your tax slips, make that final RRSP contribution, and perform other tax-related activities. 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.
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 and provinces favour 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. See the federal, provincial/territorial tax rate table.
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.
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.
From the financial newsletter Actualis Express “Income Tax 101”, @ctualis, with the collaboration with Desjardins Financial Security Independent Network.