It's All In the Math

Marginal Tax Rates and Average Tax Rate 

April 30^th is here, the last day to file personal tax returns without facing penalties and late-filing fees.  Since my regular blog day falls on this prominent day of the year, this is an excellent opportunity to discuss taxes (…once again!) In previous blogs, I mentioned how valuable it is to understand the tax brackets both prior to and during retirement.  Once you do, arranging your taxable income with the tax brackets in mind ensures the money is working to your advantage when specific tax strategies are implemented. 

The intent is also to help you understand that you may not be paying as much as you may have been led to believe.  Last week, I met with a client who was convinced his marginal tax rate (35%) was the actual amount he paid in personal income tax.  We worked through the math and although his income was substantial ($85,000), he was relieved to learn his actual tax bill was only 25% of his total income once the tax credits were applied.      

There’s nothing quite like plotting numbers onto paper to understand the calculations. People may try and explain the math but when you see the calculations worked out in front of your eyes, everything becomes clearer.  “You get it!”  Strange as this may sound, the fact is some people are afraid to earn too much income.  It’s not unusual to hear people comment, “The more I make; the more I pay in taxes.”  People I know have turned down extra shifts at work because they are afraid of income tax.   I can’t argue with the accuracy of their comment.  However, the truth is there’s enough money for both the government and you.  On the bright side, you always have more money to spend, save, or give away.  

If taxes traumatize you, let’s see if any misunderstanding can be cleared up?   One way to understand the difference between “Marginal Tax Rate” and “Average Tax Rate” is seeing the calculations.  Most people may not realize a difference exists between the two terms. We all start climbing the tax ladder from the bottom, paying the same tax rates.  The only difference is the people whose income continues to climb will pay more.  Therefore, the “marginal tax rate” refers to “the amount of tax paid on an additional dollar of income.”    For example, from the charts if income is $80,000, then the marginal tax rate would be 35%, a combination of 22% Federal and 13% Saskatchewan. However, that is not the tax rate you pay. (For a list of the tax rates in other provinces, click here.)
 

Taxes are calculated on the income earned within each bracket, factoring in any deductions which lower taxable income (i.e. RRSP contributions.)  Once this tax amount is determined, then the tax credits are applied.  Often I equate tax credits with gift certificates simply because they reduce the taxes payable.  Please ensure you fully utilize the tax credits which apply to your situation.  For an extensive list of available deductions and tax credits, click here to access this information from Canada Revenue Agency’s website.  Once the tax return is completed, the final tally determines the “average tax rate” by using this calculation: total taxes owing divided by total taxable income.
 

Each financial planner or advisor may have a unique way of explaining the difference between the marginal and average tax rate.  I believe charts create the necessary visual to notice the distinctions.  The examples given in each of the charts show that no matter if the annual income is $40,000, doubled to $80,000, or tripled to $120,000, the average tax rates still remains under 30% which is considerably less than the marginal tax rate. (This may even be lower if other tax credits are applicable. In this example only the basic personal amount is used.)

Taxable Income Calculations 2015 for Income = $40,000
FEDERAL
Income Levels	$0 – $44,701	$44,702 -$89,401		$89,401 – $138,585			$138,586 +	TOTAL INCOME		TOTAL TAXES PAYABLE
Applicable Tax Rates	15%	22%		26%			29%
Gross Income	$40,000							$40,000
Federal Taxes	$ 6,000									$6,000
SASKATCHEWAN
Income Levels	$0 -$44,028		$44,029 - $125,795			$125,796+		TOTAL INCOME		TOTAL TAXES PAYABLE
Applicable Tax Rates	11%		13%			15%
Gross Income	$40,000							$40,000
Provincial Taxes	$ 4,400									$ 4,400
TOTAL TAXES PAYBLE (FEDERAL & SASKATCHEWAN) – Before Tax Credits											$10,400
Less Tax Credits
Basic Personal Amount-Federal					$11,327			x 15%	($   1,699)
Basic Personal Amount-Saskatchewan					$15,639			x 11%	($   1,720)
Total Taxes Less Tax Credits									$ 6,981
Average Tax Rate ($6,981/$40,000)									17.45%

  

Taxable Income Calculations 2015 for Income = $80,000
FEDERAL
Income Levels	$0 – $44,701	$44,702 -$89,401		$89,401 – $138,585			$138,586+	TOTAL INCOME		TOTAL TAXES PAYABLE
Applicable Tax Rates	15%	22%		26%			29%
Gross Income	$44,701	$35,299						$80,000
Federal Taxes	$ 6,705	$7,766								$14,471
SASKATCHEWAN
Income Levels	$0 -$44,028		$44,029 - $125,795			$125,796+		TOTAL INCOME		TOTAL TAXES PAYABLE
Applicable Tax Rates	11%		13%			15%
Gross Income	$44,028		$35,972					$80,000
Provincial Taxes	$ 4,843		$4,676							$ 9,519
TOTAL TAXES PAYBLE (FEDERAL & SASKATCHEWAN) – Before Tax Credits											$23,990
Less Tax Credits
Basic Personal Amount-Federal					$11,327			x 15%	($   1,699)
Basic Personal Amount-Saskatchewan					$15,639			x 11%	($   1,720)
Total Taxes Less Tax Credits									$ 20,571
Average Tax Rate ($20,571/$80,000)									25.71%

 

 

Taxable Income Calculations 2015 for Income = $120,000
FEDERAL
Income Levels	$0 – $44,701	$44,702 -$89,401		$89,401 – $138,585			$138,586 +	TOTAL INCOME		TOTAL TAXES PAYABLE
Applicable Tax Rates	15%	22%		26%			29%
Gross Income	$44,701	$44,700		$30,599				$120,000
Federal Taxes	$ 6,705	$ 9,834		$ 7,956							$24,495
SASKATCHEWAN
Income Levels	$0 -$44,028		$44,029 - $125,795			$125,796+		TOTAL INCOME		TOTAL TAXES PAYABLE
Applicable Tax Rates	11%		13%			15%
Gross Income	$44,028		$75,972					$120,000
Provincial Taxes	$ 4,843		$ 9,876							$14,719
TOTAL TAXES PAYBLE (FEDERAL & SASKATCHEWAN) – Before Tax Credits											$39,214
Less Tax Credits
Basic Personal Amount-Federal					$11,327			x 15%	($   1,699)
Basic Personal Amount-Saskatchewan					$15,639			x 11%	($   1,720)
Total Taxes Less Tax Credits									$ 35,795
Average Tax Rate ($35,795/$120,000)									29.83%

  

If you have always believed that you were doomed to pay the marginal tax rates, you will be relieved to know you aren’t.   The design of the tax brackets and applicable tax credits is used in the final tally of the taxes owing.  This quick summary compares the various income thresholds.

Compare Marginal Tax Rate to Average Rate on Income
Total Income	Marginal Tax Rate	Taxes Before Tax Credits	Basic Personal Amount (Federal and Saskatchewan)	Taxes Payable After Tax Credits	Average Rate with Basic Personal Amount
$    40,000	26.00%	$10,400	$3,419	$  6,981	17.45%
$    80,000	35.00%	$23,990	$3,419	$20,571	25.71%
$  120,000	39.00%	$39,214	$3,419	$35,795	29.83%

 

Taxes should never stand in the way of earning more money to fuel your dreams.  If you need a purpose to wake up each morning in retirement, finding meaningful work may be the solution.  The fear of earning too much should not hold you back from doing the work you love. If you don’t need the money, helping your children or donating to charitable organizations can be rewarding.