An important consideration in financial planning
by Jamie Golombek
Are you sure you are using the correct, current and most up-to-date tax rates when engaged in retirement planning for your clients? For example, ask the man on the Clapham omnibus how much tax he would pay on $100,000 of income and the answer might be, "Oh, about 50 per cent or so".
The answer, of course, is that he would pay far less than 50 per cent tax, but the question illustrates one of the most overlooked, yet fundamental, concepts in Canadian taxation - the concept of average tax rates versus marginal tax rates. Let's explore the difference by attempting to calculate how much tax is indeed owing on $100,000 of income.
Federal tax rates
To answer the question, we must first begin with an exploration of the federal tax brackets common to all Canadian individual taxpayers, regardless of province. The chart below illustrates the income brackets and rates for 2005:
2005 Federal tax rates
$ 0 - $ 35,595
16%
$ 35,595 - $ 71,190
22%
$ 71,190 - $ 115,739
26%
$ 115,739 +
29%
It's interesting to note that the top federal tax bracket of 29 per cent only kicks in once an individual's taxable income is over $115,739. Keep in mind, of course, that this is taxable income and is, therefore, after all deductions have been claimed. For the client who maximizes her RRSP deduction in 2005 to the tune of $16,500, this translates into taxable income of over $132,000 before she even enters the top tax bracket.
Note that there is no longer any federal surtax payable. The general three per cent surtax was eliminated in 1999 and the higher income deficit-reduction surtax of five per cent was eliminated in 2000.
The other thing to keep in mind is the basic personal credit, which essentially shelters the first $8,149 of income from federal tax by providing a tax credit of 16 per cent, thus also lowering the client's effective or average tax rate.
The calculation of our client's average or effective federal tax rate on $100,000 then becomes straightforward, as follows:
Income
$100,000
$35,595 @ 16%
5,695.20
$35,595 to $71,190 @ 22%
7,830.90
$71,190 to $100,000 @ 26%
7,490.60
Less: personal credit @ 16%
(1,303.84)
Total federal tax
$19,713
Effective / average tax rate:
19.71%
Provincial tax rates
Other than Alberta, which has its own flat tax of 10 per cent, each province has its own set of tax rates and brackets, which can differ significantly from the federal brackets. In addition, each province also has its own basic personal amount.
Using Alberta for simplicity, an Albertan who earns $100,000 of income would pay a flat 10 per cent provincial tax of $10,000 but, to compensate for the lack of progressivity in Alberta's tax system, the basic personal amount is set at $14,523 - considerably higher than both the federal basic personal amount and other provinces' personal amounts. So our Albertan would pay net Alberta tax of $8,548 [$10,000 - 10 per cent ($14,523)].
So, if we tally our taxpayer's federal and provincial tax liability, we find that on $100,000 of taxable income, his marginal tax rate would be equal to 36 per cent (26 per cent + 10 per cent), while his average tax rate is a mere 28 per cent [(19,713+8,548)/$100,000] - a far cry from the proverbial "50 per cent tax bracket".
Let's ensure that we are using realistic tax rates in our financial planning models.