While it's important to understand how your taxes work so you can make informed financial decisions, the tax system is complicated. Today, the Canadian Income Tax Act is over 3,200 pages, including more than 1,000,000 words.

Let’s make the tax implications of your financial decisions a little easier to understand. In this article, we’ll review how calculating personal tax works, outline basic tax concepts and provide clarity on how the tax amount you pay is determined.

Use deductions to reduce taxable income

Understanding your income allows you to understand the tax you pay. The first step is figuring out your total income from all sources. This could include income from employment, investments, government benefits, pensions and more.

Depending on your situation, deductions could be available to reduce your total income, which would reduce the amount you’re taxed. Sometimes referred to as a "tax deduction,” these deductions reduce how much of your income is subject to tax. A common deduction is a contribution to a registered retirement savings plan (RRSP), but there are many deduction options. For example, child care or moving expenses are deductions that you might be eligible for.

Maximizing the deductions from your total income actually results in net income. After taking off your deductions you end up with your taxable income—the amount that tax rates apply to, determining the amount of tax you’ll owe.

Let’s look at an example. Nicole is a single, 35 year old Alberta resident. She works as a software developer earning $110,000 and contributes $5,000 each year to her RRSP.

By applying total tax credits of $5,332 to her calculated tax, Nicole is able to reduce her tax payable from $29,518 to $24,186.

Hint: You can find your federal and provincial tax—net of tax credits—on lines 42000 and 42800 of page 7 of your 2021 personal tax return.

Tax brackets, effective, and marginal tax rates

Identifying your tax rate can be challenging, making your tax applicable unclear. It’s not uncommon to find reference to a 40% tax rate (or more) when looking at the tax impacts on investment income, or a general sentiment that income is subject to a 50% tax rate. While it’s true that the top combined federal and Alberta tax rate reaches 48%, even at high levels of taxable income lower rates still apply for income below $322,171. Even very high levels of taxable income might barely approach an effective total tax rate of 48%.

Effective and marginal tax rates

The effective tax rate is the percentage of tax paid through each income tax bracket, divided by total income. Also called the average tax rate, it considers total tax paid and will be lower than the marginal tax rate.

The marginal tax rate is the amount of additional tax paid for every additional dollar earned as income. It applies to the incremental amount of taxable income earned. It’s useful to know when evaluating additional sources of taxable income.

In Nicole’s case, we found her tax payable to be $24,186 after all deductions and credits. On net taxable income of $105,000, this indicates an effective tax rate of about 23%. 

We also know from our calculations that Nicole’s level of taxable income reached the third income tax bracket and that a 36% tax rate applied to that portion of income. This is Nicole’s marginal tax rate. If she were to earn one more dollar of taxable income, i.e. a ‘marginal’ amount of income, this additional dollar would be taxed at a rate of 36%. 

For example, Nicole has been offered additional shift work throughout the year where she could earn an additional $10,000. Nicole could expect to pay $3,600 in taxes on this additional income and would have $6,400 of after-tax income from working the additional shifts. Despite paying tax at a rate higher than her average tax rate, the higher rate only applies to the additional income and Nicole still comes out ahead by taking on the additional work.

Financial planning considerations

Knowing your tax rate can help you to identify your after-tax cash flow, evaluate investment opportunities and create strategies to lower your overall tax bill. For business owners, it can also help in long-term planning and integration with business wealth.

To understand your own tax situation, look at your 2021 tax return to determine your taxable income, marginal tax rate and effective tax rate for the past year. How might the coming year be similar or different? Finding strategies to help reduce your taxes begins with an understanding of your income and the tax rate that applies.

¹ In 2022, the maximum federal basic personal amount is $14,398 for individuals with a net income of $155,625 or less. The amount is gradually reduced for individuals with net income above this amount, until net income of $221,708 where the basic personal amount becomes $12,719.

² The maximum annual CPP contribution in 2022 is $3,499.80. This consists of the base amount of $3,039.30 for which a tax credit is calculated, plus $460.50 representing the additional contribution for the enhanced CPP program that began in 2019. This additional contribution is treated as a deduction from income, but has been excluded in this illustration for simplicity.