Income tax for beginners

Although income tax sounds complicated, it's really not and I will show you how easy it is.

When preparing a tax return, the best approach is to focus on the federal return as the federal and provincial return are almost the same except for some miner exceptions. So let's begin, but first, I have to explain how the return is broken down:

The tax return is broken down in to four parts:

1) Taxable income

2) Tax on taxable income

3) The tax credits

4) The tax payable/refund

TAXABLE INCOME

The first part is the taxable income, the taxable income is broken down into three parts its self as total revenue, net revenue and taxable income. The reason revenue is broken down like that, there are some income programs, like the Canadian child benefit and the social assistance program, and tax credits, like the medical expense floor, are calculated on net income.

To illustrate the first part:

TAXABLE INCOME

TOTAL INCOME

1) Income +

2) Deductions (-)

Total income =

NET INCOME

3) Income +

4) Deductions (-)

Total net income =

TAXABLE INCOME

5) Deductions (-)

6) Taxable income =

As an example, you work at a grocery store. Your total yearly salary is $75,000. During the year you paid $5,000 of registered pension plan (RPP) and you also paid $900 of union dues.

TAXABLE INCOME

TOTAL INCOME

1) Employment income $75,000

NET INCOME

2) Deduction from RPP $(5,000)

3) Deductions for unions dues $(900)

4) Net income $69,100

TAXABLE INCOME $69,100

As you can see, it's pretty simple. Nothing to it. I think the reason people feel uneasy when it comes to prepare their income tax is that they see the Jacket, it's how the income tax return form is called, and see all those lines and get confused.

TAX ON TAXABLE INCOME

Now the second part is the tax calculation. The tax calculation is a bit more complex as there are several brackets. The first bracket is income lower than $49,020. If your income is lower than $49,020, then you calculate your taxable income in this tax bracket. If your income is greater than $49,020 but lower than $98,040 then you enter your income in that range. There are 5 brackets in total. See below an example of the brackets.

This is where people get confused. If you salary is greater that $49,020 but lower that $98,040. The first $49,020, the floor, is taxed at 15%, anything over but below $98,040, the ceiling, will be taxed at 20.5%. It's not the entire amount that is taxed at 20.5%, but only a portion. This is why you see in the second column, the $49,020 is deducted from the taxable income as anything over $49,020 will be taxed at 20.5%. It's the same each brackets. Each bracket has it's floor and anything under that floor is taxed in it's proper bracket.

Let's say we continue our previous example, our taxable income was $69,100, right? Now let's do the math.

TAX ON TAXABLE INCOME

Taxable income $69,100

First bracket ceiling $(49,020)

Amount to be taxed at 20.5% $20,080 ($69,100 - $49,020)

Tax rate 20.5%

Tax for this bracket $4,116 ($20,080 * 20.5%)

Tax of the first bracket $7,353 ($49,020 * 15%)

TAX ON TAXABLE INCOME $11,469

Again, the first $49,020 is taxed at 15% and only $20,080 is taxed at 20.5%.

NON REFUNDABLE TAX CREDITS

Here, I would say, most Canadians will have the same credits. I will only go through the common tax credit that people will have. I will do a complete blog on tax credits later.

There are 4 main credits:

1) the basic personal amount

2) CPP contribution tax credit

3) EI premium tax credit

4) Canada employment amount

Note there is a fifth one, the QPIP, for the province of Quebec.

In our previous example, I did not add the CPP & EI to prevent confusion, so let's add the CPP and EI here. Your salary is $75,000, therefore you maxed out on the CPP and EI. You have reach the maximum allowed CPP and EI to be deducted so the CPP and EI will be $3,166.42 and $889.54 respectively. So let's calculate the tax credits.

TAX CREDITS

1) Basic amount $13,808.00

2) CPP contributions $3,166.42

3) EI premium $889.54

4) Canada employment amount $1,257.00

Tax credits $19,120.96 (13,808+3,166+889+1,257)

Tax credit rate 15%

TOTAL NON REFUNDABLE TAX CREDITS $2,868.14 (19,120.96*15%)

TAX PAYABLE/REFUND

In the tax payable you will have the federal and provincial tax payable.

So tax payable is composed of the taxes calculated earlier less tax credits.

Tax on taxable income +

Tax credits (-)

Tax payable =

Tax withheld (-)

Tax payable/refund =

To complete our example, let's say on your $75,000 your employer withheld $12,000 of income tax.

Tax on taxable income $11,469.00

Tax credits $(2,868.14)

Federal Tax payable $8,600.86 (11,469+2,868.14)

Provincial Tax payable $2,491.00

TOTAL TAX PAYABLE $11,091.86 (8,600.86+2,491)

Tax withheld $12,000.00

Tax refund $(908.14) (11,091.86-12,000)

Your tax refund will be 908.14

Note that the provincial tax payable was calculated the same way as the federal tax return except with different tax rate and different tax credit percentage, but it's calculated the same way as the federal tax return.

Also, we haven't touched on the Quebec tax return as it is much more complicated and an additional blog will portrait the Quebec tax return. There, we will highlight the differences.

In this post, we haven't discussed self employment, pensions, social assistance program, child benefits, investment income and much more. We also, haven't discussed tax credits that can be beneficial for you. This blog was only to present the way the government calculate taxes on your revenue.