Making good financial planning decisions for you and your family involves understanding the impact of those decisions, including the effects of taxation. Financial decision-making involves many factors, and tax impacts are important to consider because the amount of tax paid can influence the timing of financial decisions, the implementation of tax planning strategies, and have long-term effects on financial goals.

As important as understanding is, most taxpayers would agree that the tax system is complicated. Today, the Canadian Income Tax Act is over 3,200 pages and contains more than 1,000,000 words. Furthermore, tax rules are continually changing, often bringing added complexities. It’s no wonder that there is often confusion when trying to understand the tax implications of various financial decisions.

In this article, we’ll review how calculating personal tax works, outline some basic tax concepts and provide some clarity on how the amount of tax you pay is determined.

Use deductions to reduce taxable income

A key element in understanding the tax you pay is to first understand your income. For tax purposes, income is reported in different ‘levels’ by a taxpayer. The first step is determining total income from all sources and may include many items such as income from employment, investments, government benefits and pensions, to name a few.

Depending on a taxpayer’s situation, deductions may be available that reduce total income. Sometimes referred to as a "tax deduction,” deductions reduce how much of your income is subject to tax. A common deduction is an amount contributed to a registered retirement savings plan (RRSP), but many other deductions exist. For example, child care expenses and moving expenses are some other deductions that a taxpayer may be eligible for, depending on their situation.

Deducting allowable amounts from total income results in net income. In certain unique circumstances, further deductions may also be available that reduce net income for tax purposes. The end result is arriving at taxable income, which is the amount of income that tax rates are applied to in determining the amount of tax.

To illustrate, we’ll consider a simple scenario with Nicole, a Canadian taxpayer. Nicole is single, an Alberta resident, 35 years old, and works as a software developer earning $110,000, and contributes $5,000 each year to her RRSP.

Considering both federal and Alberta taxes, combined brackets and tax rates applicable for Alberta taxpayers are as follows:

Nicole’s tax bracket and tax calculation

Continuing our example with Nicole, her taxable income of $105,000 puts her in the third tax bracket of $100,392 to $131,220 for the tax year 2022. While the tax rate applicable to this tax bracket is 36%, this is not the rate applied to all of her taxable income. Rather, the lower tax rates will be applied to lower levels of income and, in this case, only $4,608 is taxed at 36% as illustrated below.

Nicole’s total calculated tax amount is $29,518, or about 28% of her taxable income.

Hint: To save yourself a lot of calculations, you can find this information on your 2021 personal tax return:

• Federal tax on taxable income (Step 5, Part A)
• Alberta tax on taxable income (Part A on Form 428)

Use credits to reduce tax payable

The table above illustrates the basic structure of income tax brackets and how deductions are used to reduce taxable income. There is a base level of income, however, where no taxes are payable. This is due to the availability of tax credits.

While a tax deduction reduces taxable income, a tax credit is used to reduce the amount of tax that would otherwise be payable. Both federal and Alberta tax structures provide tax credits, with the most common being the basic personal amount.

For the 2022 tax year, the federal basic personal amount is $14,398 and the Alberta basic personal amount is $19,369. The credit, calculated by multiplying the tax rate for the lowest tax bracket by the basic personal amount, is applied against the tax calculated on taxable income. Effectively, these credits serve to eliminate tax to individuals with taxable income at or below the basic personal amount and also provide a reduction to taxpayers with taxable income above the basic personal amount.

Various tax credits exist and their availability depends on each taxpayer’s individual situation. The more tax credits that apply, the more a taxpayer can reduce their tax payable.

In Nicole’s scenario, she can utilize various federal and Alberta tax credits as indicated below.

By applying total tax credits of $5,288 to her tax calculated previously, Nicole is able to reduce her tax payable from $29,518 to $24,230. This brings us to our next point on the correct terminology of tax rates.

Hint: You can find your federal and provincial tax, net of tax credits, on lines 42000 and 42800 of page 7 of your 2021 personal tax return.

Tax brackets, effective, and marginal tax rates

Identifying one’s tax rate might be where many have a hard time quantifying the rate of tax applicable to their situation. It’s not uncommon to find reference to a tax rate of 40% or more when analyzing tax impacts on income from an investment, or reference to a general sentiment that income is subject to a 50% tax rate. While it is true that the top combined federal and Alberta tax rate reaches 48%, even at high levels of taxable income, lower rates still apply for income below $314,928. The result is that even very high levels of taxable income might barely approach an effective total tax rate of 48%. So what is the difference, and which rate applies?

In Nicole’s case, we determined tax payable of $24,230 after all deductions and credits. On net taxable income of $105,000, this indicates an effective tax rate of about 23%. The effective tax rate is the percentage of tax paid through each income tax bracket, divided by total income. Also referred to as the average tax rate, it considers total tax paid and will be lower than the marginal tax rate.

We also know from our calculations that Nicole’s level of taxable income reached the third income tax bracket and that a 36% tax rate applied to that portion of income. This is Nicole’s marginal tax rate. If she were to earn one more dollar of taxable income, i.e. a ‘marginal’ amount of income, this additional dollar would be taxed at a rate of 36%. The marginal tax rate applies to the incremental amount of taxable income earned. This is useful to know when evaluating additional sources of taxable income.

For example, Nicole has been offered additional shift work throughout the year where she could earn an additional $10,000. Nicole could expect to pay $3,600 in taxes on this additional income and would have $6,400 of after-tax income from working the additional shifts. Despite paying tax at a rate higher than her average tax rate, the higher rate only applies to the additional income, and Nicole still comes out ahead by taking on the additional work.

Financial planning considerations

Knowing your tax rate is important in a number of financial planning scenarios. It can help you to identify the amount of after-tax cash flow available to pay for your lifestyle expenses, properly evaluate investment opportunities, and identify strategies for your family to lower your overall tax bill. For business owners, it can also help in long-term planning and integration with business wealth.

To better understand your own personal tax situation, consider looking at your 2021 tax return to determine your taxable income, marginal tax rate and effective tax rate for the past year. Then consider how the coming year may be similar or different. Depending on your situation, there may be strategies available to help reduce your taxes, but it begins with an understanding of your income, and the tax rate that applies to your individual situation.

¹ In 2022, the maximum federal basic personal amount is $14,398 for individuals with a net income of $155,625 or less. The amount is gradually reduced for individuals with net income above this amount, until net income of $221,708 where the basic personal amount becomes $12,719.

² The maximum annual CPP contribution in 2022 is $3,499.80. This consists of the base amount of $3,039.30 for which a tax credit is calculated, plus $460.50 representing the additional contribution for the enhanced CPP program that began in 2019. This additional contribution is treated as a deduction from income, but has been excluded in this illustration for simplicity.