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A better understanding of how you’re taxed will make it easier to estimate how much tax you’ll pay, and reduce the chances of a surprise at tax time.
If you’re self-employed, tax time can be a source of real anxiety. Varying income from your business can mean varying tax rates, and it can quickly get confusing and unexpectedly expensive.
So what can you do to prepare for tax season?
The solution is to have a good sense of how much tax you’ll owe ahead of time. Here’s how you can build some predictability into your tax bill and be better prepared each spring.
What’s the difference between marginal and average tax rates?
Many people think the secret to knowing how much tax to pay is knowing your marginal tax rate. (See the furor in the United States over Alexandria Ocasio-Cortez’s proposed tax on those who earn over $10 million US.) As a result, they tend to use that as their tax rate and end up overpaying.
“Keep in mind, knowing your marginal tax rate doesn’t help you very much in figuring out how much you actually owe,” says Alexandra Macqueen, a Toronto-based certified financial planner.
The marginal tax rate is really about the additional taxes you may owe if your income has changed.
“The classic explanation is that the marginal rate is what you’ll pay on the next dollar of income you earn,” says Macqueen. “For example, if you earned $100,000 and you wanted to know what you would pay if you earned $100,001, then your marginal rate would help.”
In reality, your average tax rate can be a better indicator. Here’s why: Rather than paying tax at the same rate for all your income, you pay different rates for different chunks of it. Here’s a greatly simplified example. At the federal level you might pay roughly 15 per cent on the first $50,000 of income, 20 per cent on the next $50,000, 26 per cent on the $50,000 after that, and so on. To calculate your average tax rate, take the total amount you pay for all the chunks of your income and divide it by your total income. Continuing with our example, if your income was $125,000, you would pay $24,000 before deductions and credits. That’s 15 per cent of $50,000 ($7,500) plus 20 per cent of $50,000 ($10,000) plus 26 per cent of $25,000 ($6,500) equals $24,000. That means that while your marginal tax rate might be 26 per cent, your average rate would only be 19.20 per cent ($24,000 divided by $125,000 multiplied by 100).
Work with a financial professional to get a solid estimate
If you’ve never calculated your average tax rate before, consider seeking out a financial professional such as an accountant. With professional help, you can optimize your taxes for the current year and set yourself up for success in the future.
For the current year, accountants can figure out what you’ve earned, plus identify any tax credits and deductions you may claim. Once they are done with the current year, they can calculate your average earnings and your average tax rate. That will give you a baseline to work from for next year.
What to do if your income has changed drastically
If you made the same gross income as the previous year, you can use that as a guideline to figure out how much you’ll have to pay this year. This doesn’t take into account your business deductions, dividends, RRSP contributions and so on, but it will give you an estimate that you can use to put away money in your tax account.
If you made more money than last year, you can use your marginal tax rate to get a sense of how much more your taxes will be.
What if the math is too complicated or you made less than last year? Here are a couple of other options:
Use free tax tools to get an estimate. Plug in your gross income, basic deductions and contributions to your registered plans and the tool will give an idea of what you’ll have to pay this year.
Ask your accountant for a figure. Your accountant can look at your cash flow and gross earnings and give you an estimate. This may require you to book an appointment and pay for the service, but expertise is why your accountant is on your team.
Stay up to date on changes to the tax laws
Changes to the tax rules can affect your business, and business owners might not hear about every change, says Macqueen.
“The Canadian Pension Plan rates just changed,” Macqueen says. “Did the government send you a package to say, ‘By the way, you’re setting aside money for the income tax you owe and CPP’s integrated with that, so keep in mind that the rates went up?'”
A financial professional can help keep you up to date on those changes and review the impact they may have on your business and personal finances.
Stick with the process and avoid tax-season stress
Don’t let the tax process intimidate you. Instead, do a bit of homework and seek professional guidance when necessary. Then you can begin to see how much you’ll owe at the end of the tax year. That kind of knowledge will help you maximize your advantages and minimize your stress.
Source: www.sunlife.ca
Sponsored by Shannon Hood Financial Services Inc.
