How Canadian Income is Taxed /Marginal vs Average Tax Rates

Hello everyone. One of the most common questions that I get is if I earn more, will I end up paying more in taxes so my actual take home pay is less? In this video, I am going to answer that question and in the process explain to you how Canadian taxes work and with particular focus on the concept of marginal tax rates, which I think it's important for every Canadian to understand and so you can make better decisions in the future. Okay, so the Canadian tax system is based on a progressive tax system. And this means that the higher your income, the, the higher the actual tax rate that is applied to that specific income. And so the analogy that I like to use in this case is one of buckets. So in this example you can see that I have three buckets and I am going to allocate $125,000 of income. And, and the reason I use $125,000 in this case is so that you can see the application of three different tax brackets. So first of all, every level of income goes into a bucket. And then there is a tax rate that is applied to that bucket. And so you'll see here in our first bucket, we have income that is earned from zero to $55,867. And you'll see that in the first bucket, the tax rate is 15%. So again, we're looking at $125,000 of income. So that first 55,000 is taxed at 15% and you pay $8,380 in tax regardless. If you earned only 55,000, that is all you would pay. If you earn 500,000, you will also pay $8,380 on the first $55,867 of taxes. Now, because we're allocating 125,000, we still have more to go. And keep in mind, we are only using the federal rate for simplicity here. There are also provincial rates that apply. And so this will not be your tax amount. It will be different depending on the province that you are located in. Okay, so the second bucket we have another $55,866, which is then taxed at 20.5%. And so the tax rate for that is higher. So the tax amount here is $11,452, which is 20.5% of that second bucket. Now if you stopped there, and if you earned exactly $111,733, you would pay 8,380 plus $11,452, you'll see that you're not paying the full amount at 20.5%. It's only the portion above the first tax bracket. And let's just continue this onto our third bucket. And so our third bucket is taxed at anything over 111,000.

Is taxed at 26%. So in this case, because we have $125,000 salary or self employment income, that the third portion of that bucket is taxed at 26%. But again, only the $13,267 is taxed at 27.

So now if we look at the total taxes that you pay, we add up these three amounts, you'll see it's $23,282. And the average tax rate you can see is 18.6%. It is not 26%, which is what it would be if your entire $125,000 would be was taxed at 26%. So these are fixed according to these brackets or buckets. And you will always pay that amount of tax up to that amount of earnings. Now from here we have the idea of your marginal tax rate. And this I think is what confuses a lot of people, but it's an important concept to understand. The marginal tax rate essentially refers to the highest amount of tax that you're paying according to your income. So the tax bracket that applies to the final dollar of income that you're earning. In this case, you'll see that your highest level of income is in the third bucket, which is taxed at 26%. This is your marginal tax rate. And that means that every additional dollar that you earn will be taxed at 26%. So if you made $125,001, that $1 would be taxed at 26%, not the whole 125,001, but just that additional $1. And that will go up to the next tax bracket. And so this concept is important just so you know how much tax you're going to pay depending on your bucket on each additional dollar. And it also helps you make decision based on deductions. So a tax deduction essentially reduces your income and therefore the amount that goes into that top bucket, that final bucket is reduced and you pay less at that highest rate of income at that marginal tax rate. And a specific example of this is with respect to the RRSP deductions. It applies to all types of tax deductions. And that's a subject of another video. But let's just talk about RRSPs. So if you were to contribute $10,000 of RRSPs your income would be for tax purposes would be reduced from 125,000 to 115,000 and therefore when you look at this allocation, only 3,267 would go into the final bucket at 26%. Another way to look at this is that you would get back where you would reduce your taxes payable for that $10,000 RRSP contribution by $2,600. So not your average tax rate, which is 18.6%, but your marginal tax rate because contributions to RRSPs are tax deductions.

So the answer to our initial question which is will you have a lower take home pay despite earning more income? Is no, you will not because it is only the additional amounts of income that you are earning that are taxed at the higher rate. I hope this clarifies. I would love to hear your questions if anything is unclear or if you have any comments and if you found this video helpful, please like and subscribe. Have a great day.