April … tax time … Yay!!!

Actually, nobody loves paying taxes – in April or any other time of year. But maybe there is some good news to be had, by taking some time to correct a common misperception: Many Canadians assume their overall tax rate is worse than it actually is.

The confusion stems from mixing up your marginal vs. your average income tax rate. If you discover your overall tax rate is lower than you thought, you still might not jump for joy at tax time. But it might at least soften the blow. You can learn more in today’s video, or by reading on.


Cheers to Dark Beer

A distaste for taxes is nothing new, or unique to Canada. Consider a pint of Guinness Stout. Did you know this Irish brew apparently owes its popularity to an 18th century tax dodge? According to this article by Forbes tax columnist Kelly Phillips Erb, the stout’s dark complexion and unmalted appeal were originally selected to avoid onerous Irish excise taxes on the malt, and on the coal required to brew paler ales. Fortunately for the Guinness family, it also happened to taste pretty darn good. The rest, as they say, is history.

But let’s return to Canada, and your personal income taxes. Most taxpayers are painfully aware of the dollar amount of their tax bill. But when is the last time you calculated the tax rate you’re paying? Is it 20%? 30%? 50%?

To arrive at an accurate answer, we first need to understand the difference between average (or effective) vs. marginal tax rates.


Average vs. Marginal Tax Rates

Your average, or effective, tax rate is the rate you pay overall. For example, say your taxable income was $100,000 last year, and your total tax bill was $25,000. You may have paid higher or lower percentages on various parts, or tiers, of income. But your overall, effective rate was 25%.

In my experience, many people believe their effective tax rate is considerably higher than it actually is.

That’s because people often mistakenly assume their effective rate equals their highest marginal rate.

The two are not the same, because our income tax system is set up to be progressive. This means our national and provincial income tax rates are set up in tiers, or buckets of income. Each tier is taxed at a progressively, or marginally, higher rate.


Calculated Confusion

The confusion arises if you assume that, just because your taxable income falls into a higher tier, the marginal rate for that tier suddenly applies to every dollar you report. This is not true. The higher marginal rate only applies to the income dollars that fall into that higher tier.

Here are the federal rate tiers for 2018 ordinary income. (To keep it simple, we’ll omit rates on other kinds of income, such as capital gains and dividends.)


2018 Combined Federal and Ontario Income Tax Rates

Taxable Income Marginal Tax Rate
$19,820 – $42,960 20.05%
$42,961 – $46,605 24.15%
$46,606 – $75,653 29.65%
$75,654 – $85,923 31.48%
$85,924 – $89,133 33.89%
$89,134 – $93,208 37.91%
$93,209 – $144,489 43.41%
$144,490 – $150,000 46.41%
$150,001 – $205,842 47.97%
$205,843 – $220,000 51.97%
$220,000 or higher 53.53%


Say your 2018 taxable income was exactly $93,207, putting you just under the tier that would have jumped you from a 37.91% to a 43.41% marginal tax rate. Good for you!

But what if your income was instead $93,210? Will you suddenly be taxed at the 43.41% marginal tax rate on the entire amount? If this were true, you could end up with less money in your pocket because you earned more money at work. No fair!

Thankfully, that’s not how it works. Instead, you’re only taxed 43.41% on every marginal dollar, starting from the $93,209 taxable income threshold. So, if you earned $93,210, the higher rate would only apply to one little dollar. In our illustration here, your average tax rate would be closer to 23.26%.


Tax Theory, Applied

How do you determine your own effective tax rate? If you’re not into heavy-duty math, Ernst & Young offers this nifty calculator to help. You can use it to calculate your approximate 2018 average tax rate based on your taxable income. It also figures in capital gains and dividends, as well as provincial income taxes. Once the government releases its various budgets and changes for the year ahead, it’s likely Ernst & Young will update its calculator for 2019 rates as well.

Of course, your actual results may vary based on individual circumstances, but this should give you a pretty good, ballpark idea. If you’d like to take an even deeper dive into the tax pool, my PWL Capital colleague Susan Daley provides an excellent overview on her own YouTube channel, in her video, “Do You Know How Canadian Tax Works?

What other taxing concerns can I cover for you? Let me know, and stay tuned for future helpful tips on all things financial, heading your way!