Have you ever heard the phrases “my spouse is in a lower tax bracket” or “I pay a lot of tax because I’m in a higher tax bracket” and wondered how that works? Today you will find out!
What are tax brackets?
Tax brackets are tax percentages that are applied to specific ranges of income. See the Federal (Canada) and Provincial (BC) tables below.
Federal tax rates for 2015:
- 15% on the first $44,701 of taxable income, +
- 22% on the next $44,700 of taxable income (on the portion of taxable income over $44,701 up to $89,401),+
- 26% on the next $49,185 of taxable income (on the portion of taxable income over $89,401 up to $138,586), +
- 29% of taxable income over $138,586.
|British Columbia||5.06% on the first $37,869 of taxable income, +
7.7% on the next $37,871, +
10.5% on the next $11,218, +
12.29% on the next $18,634, +
14.7% on the next $45,458, +
16.8% on the amount over $151,050
The most important thing to understand with tax brackets is that going into the next bracket does not mean that your entire income is now taxed at the higher rate. I think that some people have the misconception that earning a higher income means you are now “in a higher tax bracket” so you end up paying more tax on your money than you otherwise would if you were just under the threshold.
Think of the tax brackets as a staircase. All your money on the first step gets taxed at the first
rate. Only the “overflow” money that goes into the next bracket gets taxed at the higher rate. For example, let’s say your annual income was $44,702. Only $1 would be taxed at the federal rate of 22%, and the rest would be taxed at 15%. (Yes, this is an oversimplified example to make a point! There are many other factors such as the basic personal amount on your TD1 forms and other tax credits that reduce your taxable income before the percentages are applied.) We call the highest bracket that your income is in your marginal tax rate. Meaning, if you earned one additional dollar, the federal government would take 22 cents of that dollar.
What is an average tax rate?
Your average tax rate is essentially the tax percentage that you pay averaged over your entire income (without breaking it down into brackets). Carlos’ $60,000 income has an average tax rate of 19.1% whereas Julia’s $40,000 income has an average tax rate of 14.7%. But remember: dollar for dollar, Carlos has paid the exact same amount of tax as Julia on his first $40,000. The only reason his average rate is higher is because he had to pay a higher marginal tax rate on the next $20,000.
What happens when I get a large paycheque?
Many people have heard that it is better to get vacation pay or a sales commission on a separate paycheque because you will be taxed higher if it is paid in a lump sum. This is true, but only for the short-term. When you file your taxes at the end of the year any tax that you have overpaid will be refunded to you. So what’s happening there?
Payroll programs will calculate taxes by estimating your annual income based on that period’s gross income. If the amount is larger than usual, e.g. it includes vacation pay or sales commission, the program assumes your annual income is high, and so you will be taxed more. Let’s look at an example!
Ernie’s regular gross pay is $1500 and he has asked for a vacation payout of $500.
Lump Sum: Tax on $2000 = $318.18
Separate Payments: Tax on $1500 = 191.52; Tax on $500 = 0
Net difference in tax = $126.66!
Now, all this means is that you would be avoiding paying tax now that you will probably have to pay later, but I understand wanting to have a little extra cash in your pocket now! If you are asking your payroll administrator for this, please ask nicely! Know that this is not standard procedure and will probably take twice as long for the preparer. In some cases, it’s not even possible because the program is not set up to issue multiple direct deposits.
What is income splitting?
For a couple, the combined lowest tax owing will be achieved if both parties have relatively equal income. There are strategies used to shift income from the higher income spouse to the lower income spouse to save on tax. The new Family Tax Cut was introduced for this reason to benefit Canadian couples with children and one high income spouse. Seniors can elect to split their pension with their spouse. In some cases, dividends or capital losses may be transferred to a spouse. These options will be discussed in more detail in a later post so stay tuned!
– Alicia Loewen, Coastal Tax