The title of this article refers to a question I've heard many times from clients, friends and acquaintances.
So what's the difference, and why should you care? Simply put, your marginal rate is the percentage of tax applicable to your last dollar of taxable income. Canada has a progressive income tax system, meaning that the more taxable income you earn, the more tax you'll pay. The percentages are divided into brackets of ranges of income. As your taxable income rises, it will pass from one bracket to the next and a higher rate (%) will apply. For 2020, the federal marginal tax brackets are as follows:
Note that you will pay no tax on the first $13,229 of earned income because all federal taxpayers are eligible for a non-refundable credit of 15%, called the basic personal amount, which is equal to the tax rate in the 1st bracket. Also, the brackets above are for the calculation of federal rates only. Provincial rates apply separately.
Now that we've looked at marginal rates, let's look at average tax rates. As the name implies, these can be calculated by adding up the total amount of taxes paid, in dollars, by bracket and then dividing this amount into your taxable income. If your taxable income falls into the first bracket, then your marginal and average rates will be identical. Otherwise, your marginal rate will be higher.
Now that we know the definitions, which is most important? In my opinion, while it's important to be aware of the total amount of tax we pay, which is what the average tax rate gives us, the marginal rate provides us with the means to potentially reduce our tax burden. By reducing your taxable income, you can find yourself in a lower bracket with a lower applicable tax percentage. One of the more popular methods is by contributing to a RRSP.
For example, a taxpayer earning $52,000 and making a RRSP contribution of $5,000 would reduce taxable income to $47,000. Since the upper dollar limit of the first bracket is $48,535, this would result in tax savings of 20.5% on the first $3,465 of contribiution ($52,000 - $48,535) and 15% on the balance ($1,535). In this case, it might be wise to declare the $1,535 on next year's return, assuming the same taxable income, so the contribution could generate a 20.5% savings.
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