So often the terms marginal tax rate, effective tax rate and average tax rates are discussed interchangeably without really understanding their meaning.
Let’s take a quick look at these terms and how the information they provide can help guide your financial decisions today and in the future.
For example, in 2010, Josephine’s total income from employment and investments was $69,000. Taking into consideration various tax deductions and credits, such as the basic federal tax credit , a deduction for Canada Pension Plan (CPP) contributions and Employment Insurance, the income tax payable by Josephine was approximately $17,200.
Note: All rates referred to below are based on 2010 tax year in Ontario
Average tax rate, also known as the effective tax rate, is calculated by dividing the taxes you paid, in Josephine’s case, $17,200, by your total income for the year, $69,000. The average tax rate for Josephine in 2010 would be 24.92%.
Conversely, marginal tax rate applies to each additional dollar of income earned.
To better understand marginal tax rates, it is important to note that Canada uses a stepped tax rate system. Lower amounts of taxable income are taxed at lower percentages. For example, those individuals who are earning under $30,000 will be subject to less tax as a percentage of their income, approximately an average tax of 13.35%, as compared with higher incomes where the average tax may be 33%.
The bottom line: As your income increases, the percentage of tax increases.
Using the example above, Josephine’s income is $69,000 per year with an average tax rate of 24.92%. However, the top tax rate or marginal tax rate for Josephine on the next dollar, $69,001, would be taxed at 32.92%. Further, if Josephine earned one dollar over $75,000 the marginal tax rate for the one dollar in excess of $75,000 would be 35.95% (2010).
Consider the person who receives an increase in salary and realizes they are ‘taking home’ less income. The salary increase is being taxed at a higher percentage.
What can the taxpayer do to minimize the impact of income tax on a salary increase?
A contribution to an RRSP (Registered Retirement Savings Plan) is tax deductible and as a result, would reduce the tax on the increased income. Essentially the tax on the income is deferred to retirement. The current theory is income will be lower during retirement and therefore the marginal tax rate will be lower as well. By making a contribution to a RRSP, you are deferring the income to a time when supposedly your marginal tax rate will be lower.
The Old Age clawback is the point at which a portion of Old Age Security (OAS) benefits are repaid to the government if a retiree’s annual income exceeds $66,733 (2010). An annual income of $75,000 results in approximately 50% of the OAS benefit being repaid. Compared this to the marginal tax rate of 35.39% on the next dollar earned over $75,000 from a pension or RRIF (Registered Retirement Income Fund).
For some, it is impossible to avoid OAS clawback. However, a careful review of income sources and how they are taxed can potentially reduce annual income. For example, income earned as interest is taxed at the highest marginal tax rate – 46.41% (Ontario). However, dividends or capital gains, even at the top tax rate are taxed approximately 33% and 24% respectively. Another source of income is prescribed annuities which can provide a lifetime income but at a considerably lower tax cost.
The source of the income is not the only consideration. Timing, when to start receiving CPP (Canada Pension Benefits) or RRIF (Registered Retirement Income Fund) income may be critical for minimizing annual income tax.
RRSP (Registered Retirement Savings Plan)
While a contribution to an RRSP reduces income tax and allows for tax deferral of annual investment income, the downside is the amounts withdrawn from an RRSP or a RRIF are fully taxable. Further a RRSP must be converted to a RRIF at age 71 with a minimum required payout, which of course, is fully taxable.
TFSA (Tax Free Savings Account)
While there is no tax deduction for a contribution to a TFSA, like the RRSP and RRIF, annual investment income is tax deferred. The real advantage of the TFSA is withdrawals are not subject to tax. Unfortunately the maximum annual contribution to a TSFA is $5,000. Anyone age 18 and over may contribute to a TSFA.
Like the RRSP and RRIF, the TFSA is a good vehicle for sheltering interest bearing investments that are highly taxed.
Since income can be withdrawn from a TSFA at any time without creating a tax liability, this should be the first source of funds in the event of an emergency or any unusual expense.
Before TSFAs, individuals would withdraw from their RRSP in an emergency. The result was their marginal tax rate would increase for that year thereby worsening an already difficult situation.
Planning sources and timing of income can ensure overall taxes are minimized. Understanding terms such as average and marginal tax rates will assist you in your financial decision making.