How does the income tax system work?

The following video gives an overview of personal income tax. Understanding when this is collected and how the progressive tax system works in Canada is important so that there aren’t any surprises when you file your taxes.

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Video transcript

In Canada, our government provides us with a lot of services that help us enjoy a high quality of life. In order to pay for these, we pay taxes. 

Our tax dollars pay for things like healthcare, police, schools, roads and more. They also help redistribute wealth so we can ensure we live in a more equal society. A main source of tax revenue is personal income tax. Canadians pay income tax to both the federal government and the provincial government in which they live. 

Progressive tax system

We pay taxes using what is called a progressive tax system. People who earn less money pay less tax and people who earn more money pay more. 

Tax brackets

Levels of income are divided into chunks called tax brackets. When you start to earn more money than before, the extra income is taxed in a higher bracket. Let’s use an example to see how the progressive tax system works.

Suppose someone earns $120,000. Let’s calculate the federal tax that they owe: 

  • The first $53,359 of this will be taxed in the first tax bracket at 15%
  • On the next $53,358, they will be taxed in the second tax bracket at 20.5%
  • On the final $13,283, they will be taxed in the third tax bracket at 26%

The tax rate progresses from low to high. There are five tax brackets in total with the highest tax bracket being 33% for income over $235,675

You will also pay provincial tax, which differs depending on the province you live in.

Paying your taxes

If you have an employer, they will deduct tax from your paycheque. When you submit your tax return, you will calculate if there is a difference. If your employer has paid too little, you will owe the government. If they have paid too much, you can collect a refund.

If you are self-employed, you have to save money for tax. Throughout the year, you will pay portions of the tax you owe to the government with payments called installments. These are based on what you earned in the previous year. 

When you submit your tax return, you will calculate if there is a difference and either pay the government or collect a refund. You can reduce the amount of tax you pay by using tax credits or tax deductions. 

Tax deductions

Tax deductions are the amounts that you can deduct from your taxable income. Suppose you have $1,000 in tax deductions and you have $65,000 in taxable income. You will only be taxed on $64,000. Some popular tax deductions are RRSPs, moving expenses if you move for a job or to attend school full-time and travel expenses related to work.

Tax credits

A tax credit is an amount that you can subtract from your taxes. Suppose you owe the government $15,000 in tax and you have $1,000 in tax credits. You will pay $1,000 less —$14,000. There are some popular tax credits for tuition, interest paid on student loans and for first-time home buyers. 

Tax is important because it allows us to live in the great country we do. It is also important to take advantage of the deductions and credits the government provides so that you aren’t paying more than you need to.