Most people trying to calculate their tax obligation make the mistake of applying a flat tax rate. In Canada, we are taxed according to what is known as a “marginal rate,” a much more complicated calculation. Let’s break it down!
A marginal tax rate applies to different brackets of income. For each bracket of income, a different rate applies. For example, the first $11,810 of income is taxed at a certain rate, the next $5000 or so of income is taxed at another rate, and so on and so forth, until you reach the highest tax bracket, which, in Ontario, is currently 53 percent. The more income you earn, the higher the rate of tax applied to that tax bracket.
For example, someone earning $18,000 per annum is taxed at a 25 percent marginal tax rate, while someone earning $90,000 is taxed at a 37 percent marginal tax rate.
The more money you earn, the more tax you will pay for the reasons below:
a. 25 percent of $90,000 is more than 25 percent of $18,000.
b. A higher marginal tax rate applies to the higher income earner.
It is important to keep in mind that the marginal tax rates for employment and self-employment income combine federal and provincial marginal rates.
Here are the federal marginal tax rates for 2018:
- 15% on the first $46,605 of taxable income, +
- 20.5% on the next $46,603 of taxable income (on the portion of taxable income over $46,605 up to $93,208), +
- 26% on the next $51,281 of taxable income (on the portion of taxable income over $93,208 up to $144,489) +
- 29% on the next $61,353 of taxable income (on the portion of taxable income over $144,489 up to $205,842), +
- 33% of taxable income over $205,842
While each province has their own marginal tax rates, we will look at the marginal tax rates in the province of Ontario for purposes of illustration:
- 5.05% on the first $42,960 of taxable income, +
- 9.15% on the next $42,963, +
- 11.16% on the next $64,077, +
- 12.16% on the next $70,000, +
- 13.16% on the amount over $220,000
In Ontario, the top marginal tax rate for combined federal and provincial employment and self-employment income is 53.53 percent.
Different Types of Income are Taxed at Different Rates
It is also important to keep in mind that different types of income are subject to different marginal tax rates. There are generally six sources of income:
- Employment Income
- Self-employment income
- Capital gains
- Eligible dividends
- Ineligible dividends
- Passive income (rental income, rent, interest)
- Other income (EI, OAS, CPP)
In order to calculate the tax on your income, the first step is to categorize the type of income.
The following marginal tax rates apply to employment or self-employment income:
Taxpayers who earn a capital gain will be taxed by the following marginal tax rates:
For those who earn dividend income, they will pay taxes according to the following marginal tax rates:
Top Marginal Tax Rates for Different Types of Income in Ontario
In summary, different types of income are taxed at different marginal tax rates:
a. the top combined (federal and provincial) marginal tax rate in Ontario for individuals earning employment and self-employment income is 53.53 percent;
b. the top marginal tax rate for capital gains is 26.76 percent;
c. the top marginal tax rate for eligible dividends is 39.34 percent; and
d. the top marginal tax rate for non-eligible dividends is 46.84 percent.
See chart below:
How to Calculate Your Income Tax
A tax calculator is often used to calculate one’s combined tax obligation. This is because calculating one’s tax rates is quite complex: marginal tax rates depend both on one’s tax bracket and the type of income earned.
As a result, it is recommended that taxpayers use a tax calculator, which has all the formulas built in, rather than trying to calculate their tax obligation manually.
Marginal Tax Rates and Income Splitting
One way to maximize the benefits of the marginal tax rate is to income split with a spouse or family member who is in a lower income tax bracket. The lower income earner will then pay taxes at a lower marginal tax rate. The potential for tax savings by income splitting is apparent when you consider the vast spread in marginal tax rates in Ontario alone: 53 percent for those earning in excess of $220,000 versus 20 percent for those earning just under $43,000.
While anti-avoidance rules under the Income Tax Act have largely eradicated the practice of income splitting in Ontario, there are still exceptions where income splitting is allowed. Pension income is one such category. Upon turning 65, the higher earning spouse can split up to 50 percent of his or her pension income with a lower earning spouse. That way, each spouse pays taxes at a lower marginal tax rate, lowering the total tax burden overall.
Other legal ways to income split in order to take advantage of lower marginal tax rates involve lending money to a spouse at a prescribed interest rate, lending money to your child’s trust fund at a prescribed rate of interest, and lending money to a minor to invest. These strategies are discussed in greater detail in our article on income splitting.
Both income splitting and marginal tax rates are complex topics. It is best that you consult a qualified tax lawyer to complete your tax returns and help you to reduce your tax obligation through creative tax saving strategies.
-Shira Kalfa, BA, JD, Partner and Founder
© Kalfa Law 2018