If you’re not entirely sure how to calculate your tax rate, let me explain. Today is the last instalment of my series on easy to understand and implement tax deductions.
In the first week, we discussed the new COVID-19 working from home deduction. In week two, we examined medical expenses and discussed if they can be deductible. Last week, we reviewed the Disability Tax Credit and who can claim a deduction.
This week, I am looking to the future to help you understand the 2021 tax brackets and the difference between average tax rate and marginal tax rate in the province of Ontario.
Readers of my blog know I get annoyed when Canadians complain about our tax system but haven’t taken the time to understand its basics, such as average and marginal tax rates or methods of minimizing their tax burden (like the ones described during the last three weeks).
Remember that for many Canadians, the biggest expense we face is the tax paid to our federal and provincial coffers.
If your spouse, child or business partner spent 50% each year on a specific expense, wouldn’t it behoove you to examine that expense? Of course.
So let’s take our tax returns seriously and examine options deliberately…
You will be reading this blog in late April of 2021 and, of course, it’s too late to do anything for the 2020 tax year. So I am going to look forward to the 2021 tax year.
Let’s start with the federal and Ontario tax brackets.
Your tax bracket is based on “taxable income,” which is your gross income from all sources, minus any tax deductions you may qualify for. In other words, it’s your net income after you’ve claimed all your eligible deductions.
Once you know what your taxable income is, you’ll then apply the relevant federal and provincial rates to your net taxable income. You should calculate your federal income tax first, your provincial rate second, and then add the two together. And presto!
Federal Tax Bracket Rates for 2021
In Canada, we have a progressive tax system (even if I wouldn’t call it “progressive” myself), which means that the more money a person makes, the higher the percentage of tax they pay.
The following are the federal tax rates for 2021, according to the Canada Revenue Agency (CRA):
- 15% on the first $49,020 of taxable income, and
- 20.5% on the portion of taxable income over $49,020 up to $98,040
- 26% on the portion of taxable income over $98,040 up to $151,978
- 29% on the portion of taxable income over $151,978 up to $216,511
- 33% of taxable income over $216,511
Ontario Tax Bracket Rates for 2021
In addition to the federal tax, we also pay provincial tax. In Ontario, the tax rate is :
- 5.05% on the first $45,142 of taxable income
- 9.15% on the next $45,142 up to $90,287
- 11.16% on the next $90,287 up to $150,000
- 12.16% on the next $150,001 up to $220,000
- 13.16 % on the amount over $220,000
So here’s an example of the tax calculations for Mr. Grumpy, who has a taxable income of $100,000 (all employment income or self-employment income) and resides in Ontario:
Federal tax:
15% on the first $49,020 = $7353, plus
20% on the balance between $49,020 and $98,040 = $9804, plus
26% on the balance = $510
Total federal tax is $17,667
Ontario tax:
5.05% on the first $45,142 = $2280, plus
9.15% on the amount between $45,142 and $90,287 = $4130, plus
11.16% on the balance = $1084
Total Ontario tax is $7,494
Let’s review the calculations. Mr. Grumpy, an Ontario tax payer with taxable income of $100,000 in 2021, will pay a combined federal and provincial tax of $25,161.
A common misconception lies in Mr. Grumpy’s average tax rate. Some may say it’s 37.16% (26% federal plus 11.16% provincial), but that would be wrong. It’s actually 25.16% ($25,161/$100,000).
Let me repeat this point: Mr. Grumpy’s average tax rate on $100,000 is 25.16%, which provides a tax rate paid on the taxable income earned.
Marginal Tax Rate
Now let’s continue with the example of Mr. Grumpy but assume that he gets a promotion and now earns a taxable income of $135,000. How much tax will he pay on the additional taxable income?
Hint: It’s not based on the average tax rate but what is called the marginal rate of tax. In other words, it’s the tax rate paid on the additional taxable income earned (i.e. from $100,000 to $135,000, or $35,000).
- Federal tax is $35,000* 26% = $9,100, plus
- Provincial tax $35,000 * 11.16% = $3,906
Total is $13,006 or 37.16%
Let’s review…
If Mr. Grumpy earns an additional $35,000 of taxable income, the tax on this amount is $13,006, which represents a marginal tax rate of 37.16%. So, when you earn more money, it’s the marginal tax rate that is important, not the average tax rate.
Note, his average tax rate is 28.27% ($25,161 + $13,006/$135,000). If you used the average tax rate to calculate the amount of tax on the additional $35,000, you would have underestimated the additional tax payable.
It’s the marginal tax rate that calculates the additional tax on each additional dollar of income or the tax savings on each dollar reduction of income.
In case you’re interested, the highest marginal tax rate for Ontarians in 2020 was 53.53% for taxable income above $220,000. So, if you missed my lesson, each additional dollar of taxable income above $220,000 is taxed at 53.53%. Say you earned an additional $5,000 of taxable income. The tax bite would be $2,676 and your net would be $2,323. OUCH!
Of course, that doesn’t include property taxes plus the HST paid on most purchases…
Tax Tip
Mr. Grumpy should evaluate different methods of lowering or splitting his taxable income.
Here are a few examples:
- Spousal loans
- Transfer of assets to spouse
- Pension splitting
- Spousal RRSP
- Personal gifts to children
For more information on legal methods of splitting income, have a look at my related blogs:
- Take advantage of CRA policies to minimize your tax burden as a business owner
- How to maximize tax benefits for your business
In summary, it’s important to know how the tax brackets work and the difference between average tax rate and marginal tax rate. As well, it’s imperative to examine legitimate ways to lower taxable income where available.
If you’re shocked about the amount of personal tax you paid in 2020, give me a call and let me and the specialists at Scotia Wealth review your tax structure for possible tax savings and deferral strategies.
Never Retire Profile
With the recent death of Prince Philip, the question is raised yet again as to when—or even whether—the Prince of Wales will be King. As the oldest heir apparent in British history, Charles keeps busy with official duties, charity work, environmental causes, heritage conservation, the arts, and many other interests while he waits to ascend the throne. In great contrast to his mother, who became Queen at 25 years old, and who vowed to remain in the role until her death, Charles has spent his entire life in preparation to wear the crown—and will likely wait for many more years before that happens. In a reversal of life’s typical course, he will take on the most important work of his life while in his late 70s or early 80s. Retirement is not an option!
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