Income Taxes! An Introduction

Taxes may be the most boring subject in the world, but its importance is very undervalued. Critically undervalued, for that matter. I have many friends who get all excited when telling me about a certain mutual fund or stock pick that gives 2% higher returns than expected – do you know how much the government takes from you? For many people, it’s almost 50% of your next dollar earned! Even one extra tax credit can equal to huge savings, yet people completely forget about tax planning and strategising, in order to focus on investment returns. In all of personal finance, I would say that tax planning is the most critical issue of all and ultimately has the biggest impact on your financial well-being.

In this post, I’m going to talk about the basics of income taxes – tax structure, how to fill out tax forms, etc. For many of you, this knowledge is basic and redundant; next week I will start talking about tax strategising and planning so that you can learn how to keep the most money away from the dreaded taxman, and also the impact and value of hiring a tax accountant.
First of all – who needs to file? Well, anybody who makes any kind of income. (That’s the legal answer). A lot of students who don’t earn much money don’t start filing until they enter the workplace. My advice is to start filing as early as possible. There are certain benefits to filing early even when your income is relatively small (the biggest being building RRSP contribution room for the future), which will be described later. It is extremely simple to file a return with no income.

How and where do I file? Well, there are various ways you can file – online, through a software program, or actually getting the forms and filling them out, the way our ancestors did it. Personally, I file the ancient way just because it’s the cheapest. You can pick up the forms at any Canada Post Office at this time of year. There are 2 booklets – the actual forms booklet, and the guide booklet. Make sure you pick up both for each tax filer.

These booklets contain what’s called a T1 – or personal income tax form. If you are self-employed, you need to file additional forms, including the T2125, and if you own any type of corporation, things get even trickier, and you need to file a T2, or corporate tax return. For simplicity’s sake, I will only be discussing T1’s – the return filed for the personal income you earned.

What do I need to file? Taxes involve a lot of various forms and papers. For starters – you need all of your T4 and T5 statements. These papers list the income earned by each T4/5 provider. Your employer(s), bank, investment firm – all of these institutions should have mailed you T4/5’s by the end of February. If you haven’t received them by March or you lost them, be sure to call the institution and have them print you extra copies. Hopefully now you know that the next time the bank sends you that small, double-copied paper, you won’t throw it out. As well, you need any other paper that’s used for tax credits – charitable donation receipts, insurance receipts, etc.

Here’s a great tip. At the beginning of each year, buy a binder and stick every single paper (related to tax returns) that you receive throughout the year in it, including employment papers, receipts, etc. That way, at the end of the year, you won’t go searching everywhere for those papers, because I’m not kidding – you really do need them.

Next, we will talk about the structure of the Canadian tax system. When we talk about income taxes, there are actually two entities taxing us – the federal government, and the provincial government. You actually have to fill out 2 forms, one for each government (don’t worry, it’s all included in that booklet you picked up from the Post office). First I’ll explain the federal system:
Federal Tax Brackets (Canada)



These are the 2009 federal tax rates on your income. Notice the structure here – it’s a ‘progressive’ structure. In other words, you pay $0 of taxes on your first $10,320 of income, 15% on the next $30,406 of income, and so on. If I’m earning $126,265 which is $1 above the last tax bracket threshold, my tax rate isn’t 29% - I only pay 29% on the one dollar earned above $126,264.
This should dispel a common myth about taxes. A lot of people have this idea that it’s bad to accept extra dollars of income if it pushes you over one of the tax brackets and into the next bracket. For example, if I currently earn $80,000 of income, and my marginal tax rate is 22%, and then my boss offers me a $5,000 raise (which would put me in the 26% bracket on my marginal dollar) – I might get smart and say “nice try boss! I’d rather stay in the lower tax bracket.” That reasoning is completely flawed – you only pay the higher tax rate on the extra dollars earned above the last bracket! So you should always accept more income! (I never thought I’d have to say that to someone....)

As you can see, the Ontario system works similarly but with different numbers.
So that’s it, right? Nope! Ontario charges you even more taxes, called surtaxes. This is calculated by finding your tax amount and then multiplying it by a number, depending on the tax size. That’s why there’s no set tax rate. Every person pays a different amount of tax, depending on their income and deductions. To give you an example, a typical person earning $200,000+ will be paying about 48% of taxes on their next dollar earned.

T1 – Personal Tax Form
The first page of the T1 General Form (“Income Tax and Benefit Return”) asks you for some identification. The second page asks for your income. You have to input the correct numbers on their corresponding line. To figure out what goes where, you need to use the Guide booklet. It will tell you which numbers on your T4’s goes on which line on the T1. Some of the lines (like line 121) ask you to fill out a schedule if you have that type of income. Those schedules are all included in the booklet somewhere – you just have to find it. Also, don’t get confused by the double pages – it’s just a second copy of the same document.

Line 150 is your total income. The third page allows you to deduct from your income (that’s a good thing!). Go through the lines and see if any apply to you. It is definitely worth your while to do this part carefully – adding in a number to one of those lines could mean hundreds and even thousands of dollars of tax savings.

Finally, line 260 is your taxable income. At this point, you have to fill out Schedule 1 to find the taxes payable on your taxable income. Again, go through lines 300 – 350 slowly. You want to maximise your tax credits. It can get incredibly annoying, because many lines require even more worksheets. But I cannot stress enough the savings possible – you can literally save hundreds of dollars per worksheet you fill out. If that isn’t worth your time, I don’t know what is.

Finally, at the end of Schedule 1, you come to line 420, which is your taxes payable. This number is put back on line 420 on page 4 of the T1. After that, you deduct income taxes already paid, including CPP and EI payments. How do you know if you paid taxes already? Look at your T4’s – the employer often takes off income tax for you, and CPP and EI, as required by law. Finally, you come to line 482, which is your final tax bill.

Line 482 may be negative, which means the government will mail you a refund. People get really excited by refunds, and often strive to receive a tax refund. That’s not a good thing – the only reason why you’d have a refund is because you paid too much taxes throughout the year. As such, the government got a 1 ½ year loan on your money for free. If you consistently have large refunds, ask your employer to take taxes off your regular paychecks at a lower rate. Owing taxes at the end of the year is a good thing – it means you’ve held off as long as possible to pay your taxes.

Last point – what I said before about refunds being a bad thing is only applicable if you’re a disciplined saver. If you are the kind of person that always spends money as you receive it, it may be better to continue having your employer deduct taxes for you. That way, you won’t end up at the end of the year with a big tax bill, and then wondering where all that money went.

This is the structure of income taxes. It’s a long, boring process, but it’s the most monetarily worthwhile thing to spend your time on. Next week I will delve deeper into the different deductions and credits on the T1, and show how you can manipulate those deductions and credits as much as possible.