Marginal Tax vs Average Tax

In Canada, we operate under a marginal tax rate system which simply means the more money we make, the more tax we are privileged to pay. Marginal tax is simply the amount of tax paid on an additional dollar of income. As income rises, so does the tax rate. This is different than a flat tax rate where you pay the same rate of tax no matter what your income level is.

Knowing your marginal tax rate can help you make effective financial decisions. From a planning point of view it is not good enough to just know how much money you make. It is essential to understand how much you keep. Making a dollar doesn't allow you to count on spending that dollar. Knowing your marginal tax rate will tell you how much of that dollar you can utilize toward your lifestyle. If you are planning your finances or retirement, the focus should be on your net income.

In Canada we have two layers of income tax – federal and provincial. To illustrate how marginal tax rates work, my example shows tax rates for Alberta residents and encompasses both provincial and federal tax.

For the year 2010, there are five tax brackets:

$0 to $10,382 0% (this is not really a bracket but the personal exemption level)
$10,383 to $16,825 15%
$16,826 to $40,970 25%
$40,971 to $81,941 32%
$81,942 to $127,021 36%
over $127,022 39%

If you earn $50,000 in income in 2010, then you would be in the 32% marginal tax bracket and you would pay 32% of any additional dollar you made to the federal government. If you earn $100,000, then you would be in the 36% marginal tax bracket.

One of the biggest misconceptions about tax rates is that your entire income will be taxed at your marginal tax rate. Here's an example to show you how it actually works:

The person making $50,000 per year would not pay $16,000 in tax ($50,000 x 32%). Instead, his/her tax would be calculated like this:

$10,382 at 0% = $0
($16,825 minus $10,383) at 15% = $966.30
($40,970 minus $16,826) at 25% = $6,036.00
($50,000 minus $40,971) at 32% = $2,889.28

Total tax = $9,891.58

The marginal tax rate of 32% is the amount of tax paid on any additional dollar made up to the next tax bracket. In this example, the average tax is only 19.8% ($9,891.58 divided by $50,000 of total income). Average tax is the percentage of tax paid based on your total gross income and reflects the total tax you are paying. It is the total amount of tax you will pay through all the brackets divided by total income and will mathematically always be lower than the marginal tax rate.

The tax system varies from province to province. With 10 provinces and three territories, you can imagine the complexity of the Canadian tax system. Add in the fact that the rules can change every year because of provincial and federal budgets and you have an ever-changing and complex tax system.

Lastly, paying tax is not such a bad thing because it means you are making more money. You hear people complain about paying tax and the desire to pay not tax. I have a solution . . . make no money and you will pay no tax.

But also know that no matter what tax bracket you are in, you should never ever turn down money. Our tax system works in such a way that the more you make, the more tax you will pay but you will still always win by making more money. You will never lose by making more money.

My advice to people. Learn how the tax system works before you complain. Learn how to use the system to your advantage. Spend more time on tax planning than investment planning and trying to predict the future of the markets. That's time better spent!

Other Relevant Articles

2010 Tax Rate Card - see all the marginal tax rates for all the provinces and territories in Canada

Time to do some tax planning

Three D's of Tax planning: Deduct, Defer, Divide

Article on Canadian Finance Blog – Tax Tips for 2010

TaxResource.ca is a great resource with lots of tax planning strategies for Canadians

TaxTips.ca has some great calculators on tax

Tim Cestnick is one of the most respected tax experts in Canada

Jamie Golumbek is an avid writer and has written extensively on tax planning in Canada