Making sense of income tax

With February out of the way, and the associated deluge of RRSP advertising put to rest for another year, it's time for the push to get your tax return filed. Canadians have until April 30 to file their tax return, and this is the time of year when we traditionally shove a pile of paperwork at our accountant, and hope for the best.

Although there can be a lot of number crunching involved, preparing a personal tax return can actually be pretty straightforward. I thought I'd post a general summary of the calculation of Canadian income tax.

The Basics - Marginal vs. Average Tax Rate

At its most basic, income tax represents a percentage of the income that you make in a year. If you divide your total income tax for the year by your total income for the year, you get your average tax rate. You will rarely see two people with the same average tax rate, unless they have exactly the same income. This is because income tax is actually calculated as a percentage of marginal income earned within tax brackets. For 2007, the federal tax brackets and marginal tax rates were as follows:

• $0.01 - $37,178.00 - 15% tax


• $37,178.01 - $74,357.00 - 22% tax


• $74,357.01 - $120,887.00 - 26% tax


• $120,887.01 and above - 29% tax

Therefore, if you had income of $40,000, you would pay 15% on the first $37,178 ($5,576.70), and 22% on the next $2,822 ($620.84), for a total of $6,197.54 in federal tax, giving an average federal tax rate of 15.5%.

Each province has its own marginal tax rates, which are calculated on top of federal taxes. In Ontario, for example, the 2007 provincial brackets were as follows:

• $0.01 - $35,488 - 6.05% tax


• $35,488.01 - $70,976.00 - 9.15% tax


• $70,976.01 and above - 11.16% tax

Therefore, if you had income of $40,000, you would pay 6.05% on the first $35,488 ($2,147.02), and 9.15% on the next $4,512 ($412.85), for a total of $2,559.87 in provincial tax, giving an average provincial tax rate of 6.4%.

That's the basic method of calculating income tax. Here is the CRA's list of 2007 tax rates.

Now we can get into some of the other factors that affect your income tax.

Income

Not all income is created equal. Employment income is fully taxable, while scholarship income for post-secondary students is entirely tax-free, and investment income has special tax rules. For a full breakdown of the treatment of various income sources, refer to the CRA's guide to total income for 2007.

Deductions

Deductions reduce the income on which you must pay taxes. You could say that tax deductions come off the "top" of your income, so you end up paying less tax in your top tax bracket. For example, if someone has $40,000 in income and claims a $1,000 deduction, then their taxable income drops from $40,000 to $39,000. This means that the amount of income taxed at a federal rate of 22% drops from $2,822 to $1,822, for a tax savings of $220. Compare this to someone earning $35,000, who also claims a $1,000 deduction: their federal tax savings will be only $150.

In general, tax deductions favour higher earners, since the tax savings happen in a higher tax bracket.

Examples of tax deductions are RRSP contributions, union dues, and job-related moving expenses. For a full list, refer to the CRA's list of 2007 federal deductions.

Non-refundable Tax Credits

Whereas tax deductions come off the "top" of your income, credits come off the "bottom", meaning they represent a tax savings in your lowest tax bracket. Take, for example, our $40,000 and $35,000 earners from above. If each of them claims a $1,000 federal tax credit, then they will each save $150 in federal taxes.

The "non-refundable" nature of the tax credits simply means that these credits can only be used to offset taxes owing; if you owe $100 in taxes without any credits, and claim a $1,000 credit, you will owe $0 in taxes, as opposed to being owed $50 by the government. In most cases this extra $50 can be carried over to the next tax year.

Tax credits are considered more equitable than deductions, since they do not favour high-income taxpayers over low-income individuals.

Examples of non-refundable tax credits are the Basic Personal Amount, the Canada Employment Amount, and CPP and EI contributions. For a full list, refer to the CRA's list of 2007 federal credits.

Charitable Donations

Charitable donations are treated as a tax credit, but there's a slight twist. The first $200 of donations in a given year generate a credit in your lowest bracket, and any amount above $200 generates a credit in the highest bracket (regardless of whether you have income in that bracket). This means that a donation of $300 would translate to a $200 federal credit at 15%, and a $100 credit at 29% regardless of your income.

If you are filing jointly with your spouse, you can (and should) pool your donations together on one return. If each spouse makes a $300 donation and claims it individually, then each spouse will have a federal tax savings of $59 (15% of $200 plus 29% of $100), for a household total of $118. Compare this to one spouse claiming $600 in donations, for a federal tax savings of $146 (15% of $200 plus 29% of $400). Similarly, if you plan to donate $300 this year and next year, it may be more beneficial to wait until next year to claim this year's donations. The idea is to minimize the number of "transactions" that are subject to the $200 threshold.

Other Taxes

Ontario residents pay a health premium, based on their income level, to subsidize health care. Several provinces, including Ontario, are also subject to a provincial surtax. For example, the 2007 Ontario surtax applies to provincial taxes as follows:

• $0.01 - $4,100.00 - 0% surtax


• $4,101.01 - $5,172 - 20% surtax


• $5,172.01 and over - 56% surtax

Note that the surtax is applied to the provincial taxes owing, not to taxable income. If an individual owes $6,000 in Ontario taxes, then their surtax will be 20% of $1,072 ($214.40) and 56% of $828 ($463.68) for a total surtax of $678.08.

A good rundown of all the provinces' applicable taxes is provided at Taxtips.ca.

Pulling It All Together

That's a lot of material to digest, so let's bring everything together with an example. I'm most familiar with Ontario taxation, living as I do in Toronto, so this will be an Ontario-centric example.

Particulars

• Employment income: $50,000.00


• RRSP contributions: $5,000.00


• Charitable donations: $500.00


• Income tax withheld by employer: $9,500.00


• CPP contributions paid: $1,989.90


• EI premiums paid: $720.00


• No "special" credits apply

First, let's calculate our friend's taxable income. The $5,000 RRSP deduction takes total taxable income down to $45,000. This is the amount that is subject to federal and provincial taxes. The taxes owing would be calculated as follows:

Federal Tax

• 15% of $37,178 = $5,576.70


• 22% of $7,822 = $1,720.84


• Total federal tax = $7,297.54

Ontario Tax

• 6.05% of $35,488 = $2,147.02


• 9.15% of $9,512 = $870.35


• Total Ontario tax = $3,017.37

This gives us the gross federal and provincial income tax amounts. Now, let's determine the non-refundable tax credits:

Federal Non-Refundable Tax Credits

• Basic Personal Amount = $9,600


• Canada Employment Amount = $1,000


• CPP Contributions = $1,989.90


• EI Premiums = $720.00


• Total federal credits = 15% of $13,309.90 = $1,996.49

Ontario Non-Refundable Tax Credits

• Basic Personal Amount = $8,553


• CPP Contributions = $1,989.90


• EI Premiums = $720.00


• Total Ontario credits = 6.05% of $11,262.90 = $681.41

Now factor in the charitable donations:

Federal Tax Credit

• 15% of $200 = $30


• 29% of $300 = $87


• Total federal credit = $117

Ontario Tax Credit

• 6.05% of $200 = $12.10


• 11.16% of $300 = $33.48


• Total Ontario credit = $45.58

Now determine the net taxes owing:

Federal Tax

• Gross income tax = $7,297.54


• Non-refundable tax credits = $1,996.49


• Charitable donation credit = $117.00


• Net federal tax = $5,184.06

Ontario Tax

• Gross income tax = $3,017.37


• Non-refundable tax credits = $681.41


• Charitable donation credit = $45.58


• Net Ontario tax = $2,290.39

Since the net Ontario tax is below $4,100, there is no applicable surtax. This individual's taxable income is $45,000, which translates to a $450 Ontario health premium. Therefore, the total taxes owing are as follows:

• Net federal tax = $5,184.06


• Net Ontario tax = $2,290.39


• Ontario health premium = $450.00


• Total tax payable = $7,924.44

This individual owes $7,924.44 in taxes for the year. However, because the employer has already withheld $9,500 in income taxes, there will be a tax refund of $1,575.56.

That's the basic nuts and bolts of how taxes are calculated in Canada. There are, of course, more complicated situations, for which a tax professional should be consulted. At the very least, however, this guide should help you to estimate your own return, so you know roughly what to expect.