7. Tax Basics and "The Next Bracket" Myth

Transcript:

Hello and welcome to S01E07 of the Canadian Money Roadmap podcast. I'm your host, Evan Neufeld and today we are going to talk about tax.  Just the basics today and we'll cover off the “next tax bracket” myth. 

Now when people hear the word tax, most glaze over immediately, choose to ignore it or in some cases they get angry because they actually hate the idea of paying taxes altogether. This episode is going to be very quick and just cover the basics of how the Canadian tax system works from a high level and then the biggest myth when it comes to paying tax.  

In Canada, we use what's called a progressive tax system which just means that the more money you make, the more tax you'll pay. You've likely heard of tax brackets before and those are just the thresholds that your income reaches before you pay a higher rate of tax. 

Think of your income like water filling up a measuring cup.  On the measuring cup there'll be different markers for how much tax you need to pay at that level. So I'll give you an example here, but since each province has different tax rates and brackets, let me use generic hypothetical numbers for simplicity just to explain these measuring cup type markers.  Say for example, your first 25,000, you pay 10% tax. Then as your measuring cup fills up a little bit more from 25,000 to 50,000, you paid 25% tax. Then from 50,000 to a 100,000 you pay 33% and so on. If in this example you make $75,000 then you pay 10% tax on your first 25,000, 25% tax on the next 25,000, and then from 50,000 to 75,000 you pay 33% tax on that.  

If you're still with me and my example, if you get a bonus of $5,000, you'll pay 33% tax on the full amount because that additional $5,000 falls within that bracket. Since 33% is the amount of tax you pay on the next additional money you earn, that's referred to as your marginal tax rate.  Marginal being what you pay on the next dollar. 

But as I've explained, you don't pay 33% tax on every dollar you earn. You paid 10% on the first, 25% on the next, and 33% on anything after that. So your average tax rate in my example here is actually 23%. So you're in the 33% tax bracket, that's your marginal rate, but you pay about 23% tax on every dollar you earn on average. 

This is the biggest misconception when it comes to understanding tax.  I've heard really scary and honestly sad stories where people have turned down overtime, bonuses or raises because they think that once they’ve exceeded their current tax bracket, they'll actually make less money and that's simply not the case. 

This is the “next bracket” myth that says if you move into the next bracket, you'll pay more tax on every dollar you earn and that's simply not so. Keep in mind the difference between marginal and average.  Any additional money you earn will be taxed at your marginal tax rate and will have no effect on income you've already earned in the lower brackets. The reason the next bracket myth exists is because in some cases your take home pay might not actually go up depending on your situation. But this is simply just due to the calculation that your payroll system uses for bonuses or overtime. In this case, the increase in pay for that one month, two-week period or whatever the case may be, triggers something on their system that says to take off more tax on your check which in some cases can actually be more tax than you really owe.  But if you find yourself in a situation where you save a bonus, raise or work overtime and your take home pay actually does decrease, you will receive the correct amount back when you file your taxes. At the end of the year, it's just a bit of a calculation glitch when things like that happen in the middle of the year. 

So keep in mind that it's always worth it to take the extra pay. Just so you have an idea of whether the appropriate amount of tax is being deducted, understanding your pay stub is really important. Most pay stubs are pretty basic and so I've attached a link to the show notes to show an example from the Government of Canada that explains how income is calculated and some of the basic deductions that will happen before the money is deposited into your account. If you work overtime or receive a raise or bonus, you can do a calculation yourself based on how much tax they deduct on your behalf. If they deduct more than your expected average rate, then you can expect a refund at the end of the year. 

So to have a better understanding of what that average and marginal rate might be in the province that you live in, I’ve also attached a link in the show notes to a basic tax calculator from  an accounting firm.  You can simply type in your expected annual income and then look on the chart to find your province of residence.  It'll tell you exactly what your taxes payable are, your average tax rate, and then your marginal tax rates. Your average tax rate is simply your total taxes payable divided by your income, pretty simple math. The marginal tax rate is what you pay on the next dollar you earn. So if you earn more money, your marginal tax rate might jump up, but only if you hit the next threshold or bracket.  Your average tax rate should increase at a more consistent rate than your marginal tax rate will. 

So to summarize, the more money you make, the more tax you pay, that's called a progressive tax system. We use thresholds or brackets to determine how much more you need to pay. When you earn more money, the bracket only tells you how much you pay within that bracket, not how much tax you pay on every dollar you earn. 

Again, think of the measuring cup idea, where your income fills up that measuring cup. When you work overtime, receive a bonus or a raise you should always accept it because you'll make more money. Even if you move into the next tax bracket, you'll only pay more tax on the money you earn within that bracket. 

Sometimes this needs to get corrected at the end of the year come tax time, but the government will never take all of it. As I mentioned before, sometimes there are anomalies based on how your payroll system deducts taxes from your check. So always look at your pay stub so you can do your own calculations to make sure there are no surprises at the end of the year. Having to pay tax when you file is fine, but only if you know in advance and you can save cash accordingly. 

Personally, I'd rather keep as much of my own money as possible and pay later.  Because receiving a refund just means that you gave the government too much money ahead of time and they don't pay you any interest. But that's another topic for another time. 

Thanks for joining me today on the Canadian Money Roadmap podcast. If you enjoyed today's episode, I'd really appreciate if you left me a review on Apple podcasts with your biggest takeaway. If you have questions or ideas for topics you'd like me to discuss in future episodes, please reach out via my contact info in the show notes. 

This podcast is intended to be educational in nature, and you should always consult your Financial, Tax and Legal advisors before making changes to your financial plan. Any rates of return discussed are historical or hypothetical and are to be used for educational purposes only. Evan Neufeld is a Qualified Associate Financial Planner and Registered Investment Fund Advisor.  Mutual Funds are provided through Sterling Mutuals Inc.