Financial Literacy

Unit 1 – Income Taxes

Lesson 3: Average & Marginal Tax Rates

 

Average Tax Rate vs Marginal Tax Rate

When financial professionals analyze an individual’s tax situation, they often direct some of their focus to these two statistics of each person.  These statistics, which come in the form of percentages, are a product of the tiered tax brackets that we have just discussed in our last article, and together they can play a role in directing an advisor to the strategies that best suit each individual. 

These two percentages are a taxpayer’s Average Tax Rate and Marginal Tax Rate.

 

Average Tax Rate (ATR)

I will start by first explaining the Average Tax Rate (ATR), because I believe of the two, it is the easier to understand as far as the way in which it is derived.  Simply put, the ATR is just the amount of total taxes owed, divided by the amount of total taxable income that you earned.  This provides the amount of income, in the form of a percentage, that will go to tax.

The ATR is the tax rate that most Canadians are familiar with because if you earn a salary from a company, then your paycheque is provided net of taxes, and these taxes are determined by your expected ATR for that year.  This is the case because usually, if you’re a full time employee on salary, or if you have a set amount of weekly hours, the company will be able to project your total income over the span of a full year, and hence they can deduct your expected ATR from your paycheque.  Obviously, if you’re an hourly worker, or if you have overtime available to be made, this might lead to a slight discrepancy at the year’s end, and this may lead to a taxpayer being owed a tax refund or owing additional taxes upon filing. 

 

Example 1 - $125,000 of Gross Income in British Columbia

 

From the information provided in the table above, we are able to calculate the Average Tax Rate (ATR) for this individual by dividing the Total Income Tax by the Total Taxable Income. 
In this case, the ATR is 25.90% ($32,371.32 / $125,000).

 

Example 2 - $70,000 of Gross Income in British Columbia

 

From the information provided in the table above, we are able to calculate the Average Tax Rate (ATR) of this individual by dividing the Total Income Tax by the Total Taxable Income. 
In this case, the ATR is 19.19% ($13,430.68 / $70,000).

 

Marginal Tax Rate (MTR)

Defined, the MTR reflects the taxes that an individual will pay, represented as a percentage of the income, if he or she was to earn one additional dollar of income.  As discussed in our most recent article tax brackets increase as you earn more employment income.  This means that as your income increases, you fall into higher tax brackets. Each time you enter a higher tax bracket, you are taxed at a higher rate than the previous bracket. Although both the Federal and Provincial tax rates are increasing, they do so at different tax rates, and at different income thresholds, so in order to identify what a taxpayer’s MTR is, we have to follow the following steps.

• Determine the exact Total Taxable Income.
• Determine which Federal Tax Bracket that is associated with that level of income.
• Determine which Provincial Tax Bracket that is associated with this level of income.

(I have assumed that the taxpayers in our examples both live in British Columbia)

• Add the two corresponding Tax Rates.

 

This is the reason overtime or bonuses are usually taxed higher than your regular  hours or salary, because this additional income is all being taxed in your highest tax bracket, at your Marginal Tax Rate.

 

Example 1 - $125,000 of Gross Income in British Columbia

In the example of the British Columbian individual earning $125,000 in 2020, her Marginal Tax Rate would be 40.70%.  The taxpayer would fall into the Federal Tax Bracket of $97,069.01 to $150,473, with a resulting tax rate of 26.00%.  She would also be subject to a BC Provincial tax rate of 14.70% as her total income falls between $116,344.01 and $157,748. 
By summing up the 26.00% and 14.70% we arrive at the total MTR of 40.70%. 

 

Example 2 - $70,000 of Gross Income in British Columbia
In the example of the British Columbian individual earning $70,000 in 2020, his Marginal Tax Rate would be 28.20%.  The taxpayer would fall into the Federal Tax Bracket of $48,535.01 to $97,069, with a resulting tax rate of 20.50%.  He would also be subject to a BC Provincial tax rate of 7.70% as his total income falls between $41,725.01 and $83,451. 
By summing up the 20.50% and 7.70% we arrive at the total MTR of 28.20%. 

Summary

As is depicted in the two examples, the individual from Example 1 has both a higher Average Tax Rate and Marginal Tax Rate.  Although their Average Tax Rates are not drastically different (25.90% versus 19.19%), the same cannot be said about their Marginal Tax Rates (40.70% versus 28.20%).  That means that if both individuals were to earn one additional dollar of income, $0.41 would be paid in taxes by the individual in Example 1, and $0.28 will be taxable for the individual in Example 2. 
By incorporating strategies that reduce the amount of taxes that you must pay, or claiming the tax credits you are eligible for, you are able to reduce your ATR.  Essentially, by lowering your ATR you are reducing the amount of money that goes to the ‘tax-man’ and increasing the amount that stays in your pocket.
By identifying which tax-bracket you fall into, advisors who work in the financial landscape, including tax professionals, can identify strategies that align with your specific needs.  The most common example would be the use of a Registered Retirement Savings Plan (RRSP) in conjunction with your MTR to take advantage of the tax return, but that is a conversation we will cover in subsequent Units.

 

Works Cited

BC Tax Rates: https://www2.gov.bc.ca/gov/content/taxes/income-taxes/personal/tax-rates
Federal Tax Rates: https://www.canada.ca/en/revenue-agency/services/tax/individuals/frequently-asked-questions-individuals/canadian-income-tax-rates-individuals-current-previous-years.html#provincial
BC Basic Tax Credits: https://www2.gov.bc.ca/gov/content/taxes/income-taxes/personal/credits/basic