You know how everyone, when self-assessing themselves, is smarter than average and better looking than average? Well, your marginal tax rate is higher than average….I guarantee it!
The following table shows the marginal tax rate and average tax rate at various income levels. As promised, the marginal tax rate is always higher than the average!
This is not a surprising result, mathematically, since Canada has a progressive tax system (which means income earned in higher tax brackets are taxed at higher rates).
Does it surprise you that someone earning $120,000 only pays 26.3% of that in tax? However, if they earn an extra $1,000, that extra $1,000 will be taxed at 43.4%, or $434 of tax. Here’s how taxes are actually calculated for an income of $120,000:
I hope between the above table and our discussion in the last post, we can agree on what your average tax rate is versus your marginal tax rate. Very importantly, it is key to understand that your average tax rate is often far less than your marginal tax rate; it’s the marginal rate that most people focus on. And now you know that your marginal tax rate is always higher than your average tax rate.
Why is your marginal tax rate so important?
The marginal tax rate is important to measure changes in your taxable income (e.g. earn an extra $1,000 dollars which increases your taxable income or contribute $1,000 to your RRSP, which reduces your taxable income). In the example above at a $110,000 income level, if your taxable income goes up or down by $1,000, your taxes owed will go up or down by 43.4%, or $434.
Overall, your marginal rate is important for tax planning for situations such as:
- How much tax you’ll pay if you earn an extra dollar
- Rental income, side hustle, overtime (as discussed in the previous post)
- How much tax you’ll be refunded if you contribute an extra dollar to your RRSP
- How much tax you’ll save if you can income split with your spouse or kids
- How much tax you can defer or avoid through other tax planning strategies
Why is your average tax rate important?
Average tax is important for estimating total taxes in your budget. If you’re planning to live on $56,000 after-tax when you retire, then you’ll need $69,000 before tax. That is because the average tax rate is about 19%, so $69,000 less $13,000 (rounded) in taxes equal $56,000.
To summarize, your average tax rate is important for:
- Estimating after-tax income when budgeting for your annual expenses
- Planning after-tax income needs in retirement
Now that you know the difference between marginal and average tax rates, I can assure you that you’re better than average! 🙂
More resources if you would like to read about this from different angles: