Understanding Different Tax Rates: Marginal vs. Effective

by Greg DePersio

2 min read

Navigating Canada’s tax laws can be a complicated task since federal tax rates and rules frequently change from year to year. Provincial and territorial taxes, which vary from place to place, also change frequently, while personal and corporate income get taxed differently. Perhaps most confusing, Canada assesses taxes in tiers based on total income, which can make it difficult to know how much you must pay based on the money you make. The first step to untangling the messy tax code comes down to learning the difference between marginal and effective tax rates.

Marginal Tax Rate

The Canada Revenue Service (CRS) divides taxes into income tiers called margins. As of 2016, the lowest federal tax margin sits at 15% and applies to income of $45,282 or less. In other words, no matter how much you make, the first $45,282 of your income gets taxed at 15%. The next margin of 20.5% applies to income between $45,282 and $90,563. So if you make $90,000, you owe 15% on the first $45,282 and 20.5% for every dollar over that amount. The top federal tax margin in Canada rises to 33% and applies to all income earned in excess of $200,000. This means your marginal tax rate comprises what you pay on your last dollar of income. A person earning less than $45,282 has a marginal rate of 15%, while a person earning more than $200,000 has a marginal rate of 33%.

Effective Tax Rate

Your total tax liability as a percentage of your income is your effective tax rate. Determining your total tax liability involves calculating tax owed at each margin up to your total income. To simplify, assume the first $50,000 of income has a 10% tax rate, and the next $50,000 has a 15% tax rate, with the marginal rate increasing by 5% for every $50,000 of income. With those numbers in mind, if you earn $125,000 for the year, it puts your income at a marginal tax rate of 20%. Your total tax liability comprises the sum of what you owe for each margin, or tier, of your $125,000 income. For the first $50,000, you owe 10%, or $5,000. Your tax on the next $50,000 comes to 15%, or $7,500. Then you have $25,000 remaining, for which the CRS assesses a rate of 20%, or $5,000. The sum of these figures, or $17,500, adds up to your total tax. You can calculate your effective tax rate by comparing this figure to your total income — the amount of $17,500 divided into $125,000 comes to 0.14, or 14%.

Why It Matters

Knowing your marginal and effective tax rates can help with business planning and tax savings. For instance, if you run a bookkeeping business as a sole proprietor and a client hires you for a project toward the end of the year with two payment options, you can choose to get your money up front in December or opt to take it when you finish the job in February. If you sit right at the top of your current tax margin, it might be smarter to defer payment, as receiving it upfront would result in a higher tax burden. Tax codes can seem complicated and confusing, but understanding the difference between marginal and effective tax rates simplifies the process. By understanding how and when payments affect your business, you can better plan for the future and keep more cash in your account.

References & Resources

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