Getting a firm grasp of our complex tax system is one of the most important components of financial literacy, yet it's often overlooked.
Literacy efforts more often focus on educating Canadians about the importance of balancing a chequebook, knowing the difference between a stock and a bond, and whether to choose a longer or shorter amortization period on your mortgage.
Yet for many Canadians, personal income taxes are their largest household expense and a good opportunity for savings.
In honour of Financial Literacy Month, I present three of the most common gaps in tax knowledge: Credits vs. deductions It's amazing how many people are still stuck in 1987 before our major tax reform switched many of our tax deductions to tax credits. What's the difference between a credit and a deduction? A credit reduces your tax payable while a deduction reduces taxable income.
So, which would you prefer? That depends on your tax bracket. Other than the two-tiered donation tax credit, all other non-refundable credits are calculated at the lowest federal rate of 15%. If you are in the lowest federal bracket, with taxable income below $42,707 in 2012, you will pay tax at a rate of 15%. Whether you deduct $1,000 from your taxable income and save 15% tax or get a credit for $1,000 calculated at 15% against your taxes payable, it will make no difference to the amount of after-tax cash in your pocket.
On the other hand, if you're in a higher bracket where your income for 2012 is more than $85,414 and you pay tax at a federal rate of 26%. In this case, given the choice of a $1,000 deduction versus a $1,000 credit at the non-refundable credit rate of 15%, clearly the deduction of $1,000 that saves tax of 26%, or $260, is worth more that the credit of $1,000 at 15% that saves tax of $150.
Medical expenses While most Canadians know that there is a medical expense credit available for the cost of unreimbursed medical expenses, what they forget is that there is a minimum threshold amount which you must exceed first. For 2012, you must spend at least 3% of your net income (up to a maximum of $2,109) before you get any credit for medical expenses. In other words, if your net income for 2012 is $60,000, you must have more than $1,800 in medical expenses before getting a credit for any excess above this amount.
TFSA contributions Finally, even the relatively new TFSA rules have confused many Canadians, who think of themselves as otherwise financially literate. The rules state that any TFSA withdrawals can be recontrib-uted beginning the following calendar year. Yet this rule has confused tens of thousands of taxpayers, who were hit with penalty tax for over-contributions and who then had to explain their circumstances to the Canada Revenue Agency to get their tax cancelled.