Personal Finance 101: Income & Taxes

Peter's picture

Welcome to the second installment of the www.planyourescape.ca Personal Finance 101 series: a closer look at Income & Taxes. If you missed the previous post which gave an overview of personal finance concepts then you might be interested in taking a look at it now.

Just a quick note for our friends in different countries: the tax information presented here is unique to Canada. However, you should look into your local taxation laws to see if something similar would apply. I recommend reading this anyway since the overriding lesson is still applicable. It's not how much you earn, but how much you keep.

Income is Great. After-Tax Income is Better.

Probably one of the most exciting things about personal finance is making money. As we learned previously, when we make money we call it income. Most of us are familiar with at least one, if not a couple, common sources of income. The most common income source is employment income. Another common source is interest income, say from a savings account. I'm going to talk about 4 different income types today: not just employment and interest, but also capital gains and dividends. I'll also examine the different taxes and deductions that apply to these different income types and we'll see that there are some significant differences at the end of the day. I was actually surprised!

As usual, let's start things off with a diagram showing all four income types and their respective taxation levels.

Personal Finance 101: Income & Taxes: A breakdown of four different income sources (employment, interest, capital gains and dividends) and their respective income tax treatment in Canada.Personal Finance 101: Income & Taxes: A breakdown of four different income sources (employment, interest, capital gains and dividends) and their respective income tax treatment in Canada.

This illustration shows us how $100 of each type of income is affected by income taxes. I'm assuming a Canadian taxpayer, living in Ontario, paying taxes in the lowest tax bracket (ie they earn less than ~$35,000 in total annual income). As you can see, our good friend employment income ranks the lowest of all four types and the lowly dividend comes blazing in at number one. Want to learn more? OK, well let's take a look at each income type individually and I'll try to explain what's happening.

Employment Income

Employment income is the most common and most familiar type of income. This is where you give your time and expertise in exchange for a salary or a wage. This is usually the primary source of income for most people. Typically you will be compensated for your efforts every two weeks or so in the form of a pay cheque. Funnily enough, it is by taking a look at that bi-weekly pay cheque that we see why employment income leaves us with so much less at the end of the day.

If you look at your pay cheque (or pay stub if you get paid by direct deposit into you bank account) you'll usually see three columns:

  • Gross pay - This is what your employer puts on your employment contract. If you are earning $35,000 per year, your gross pay will be $35,000 / 26 = ~$1,385 on each pay cheque.
  • Deductions - This is where we take it on the chin. There are usually three main deductions:
    • Income Tax Deduction - For someone earning $35,000 annually, you'll pay around $300 each pay period.
    • Employment Insurance (EI) Deduction - This works out to be almost $25 per pay period if you are paid $35,000 anually.
    • Canada Pension Plan (CPP) Deduction - And the last blow comes in at about $68 every two weeks.
  • Net pay - After the government has finished with you, you are left with about $992 which is quite a bit less than the $1385 that you started with.

So once you take those taxes and other deductions into account, you are actually earning a lot less than you thought you were. I'm only looking at taxes here, but the picture gets a lot more bleak when you account for gas, vehicle mileage, work clothes and lunches. So, I guess what I'm getting at is that employment income comes in solidly at back of the income pack.

Feeling depressed? Don't worry, it only gets better from here.

Interest Income

Another familiar concept if that of interest income. Most people have had a savings account at one point or another that paid a small amount of interest on the money that you kept there. Bonds and guaranteed investment certificates (GICs) are some other sources of interest income.

Interest income is taxed at the same rates as employment income except that there are no EI or CPP deductions. As we see from the first chart, we are only keeping $78.45 for each $100 we get in interest income (in the lowest tax bracket). So interest income is definitely a step up but we are still paying tax at the full rate. So, interest slides in at third place.

Capital Gains Income

Capital gains arise when you buy something, then it goes up in value and then you sell it for more than you paid for it. A good example is house flipping: you buy a house, do some quick work on it to make it better and then you sell it for much more than you paid for it in the first place. Any profit you make in this case would be considered a capital gain. Another common way to get capital gains is by buying and selling stocks or mutual funds. If you buy a stock for $10 and sell it for $15, you will have earned $5 in capital gain income.

In Canada, you only pay taxes on half of your capital gain amounts earned. So, for example, if you bought a stock for $10 and sold it for $50 dollars, you will have earned $40 in capital gains. The Canadian government requires you to pay tax on half of that, or $20. So you are getting half of your total capital gain tax free. Not bad. As we see from the chart above, we are keeping almost $90 of the $100 we earned.

So, capital gains finish in second place overall. Now on to dividends ...

Dividend Income

Now the moment you've been waiting for ... or maybe you just skipped down to this section directly. The fourth and final type of income we're covering is dividend income. Specifically, dividend income from publicly traded, Canadian corporations, otherwise known as eligible dividends. Normally, a Canadian corporation will announce when they declare a dividend whether the dividend is an eligible dividend of not. Most dividends from publicly traded, Canadian corporations are eligible. Dividends from other sources (e.g. from foreign corporations) are treated as interest income in the eyes of the Canadian government.

In general, when a corporation makes a profit it can choose to retain those earnings to reinvest in the company or it may choose to pay some of the earnings to its shareholders directly. When a corporation pays its earnings to its shareholders it is called a dividend. Since a Canadian corporation has already paid tax on its profits, the Canadian government gives a tax break to Canadian shareholders so that tax is not paid twice on the same money. It gives this tax break in the form of a dividend tax credit.

The actual mechanism for the tax credit is a bit complicated but I'll briefly explain. If you don't understand completely, don't worry. I'll use the $100 of dividend income as shown in the first diagram above. When you earn $100 of eligible dividends it gets what is called grossed up to 145% of the original amount. So $100 of dividend income becomes $145 of income. Then, you get a dividend tax credit in return. You get a credit of 18.966% from the federal government and 6.7% from the Ontario government (other provinces have similar credits but for now we'll just look at Ontario). So ...

  • You get $100 in eligible dividends
  • That income gets grossed up to $145 of income. You don't actually get this money; it just gets reported on your tax return this way.
  • You get charged taxes on $145, so you owe $31.25.
  • Then you get a tax credit of $37.22 (more than the tax you owe!)
  • Leaving you with $5.97 to offset other taxes owing. This money is not directly refundable so it can only be used to offset other taxes that you owe. So you don't get to take advantage of it unless you have some other income that you owe taxes on ... which isn't normally a problem!

Pretty amazing, eh? I was quite surprised when I did these numbers since the last time I looked the tax credit was a bit lower. Now, with the current dividend tax credits, a person in the lowest tax bracket can actually reduce their total taxes by having some dividend income mixed in with their other income.

So, clearly, eligible dividends come in at number one.

Summary: Income Equivalence

Let's finish by looking at the whole picture from a slightly different point of view. Instead of looking what happens to $100 of each different income type, let's look at how much of each type of income you would have to earn to leave you with $100 in your pocket at the end of the day.

Personal Finance 101: After Tax Income Equivalence: Here we see a comparison of the pre-tax earnings, for four different income sources, required to leave $100 in your pocket after taxes.Personal Finance 101: After Tax Income Equivalence: Here we see a comparison of the pre-tax earnings, for four different income sources, required to leave $100 in your pocket after taxes.

No surprises here. Just a different way to look at the situation. If you are still wondering which is best, just look at the face on our stick figure friend.

So in the end we can see that our most common source of income, employment income, is the least effective at providing us with after-tax money. Fortunately, employment is also the least enjoyable way of earning income ... at least I think so. So, let your money work for you instead of you working for your money. Take some time to investigate some of these other sources of income to see if they would work for you. Your bank account will love you for it!

I hope you enjoyed the article. Please leave any comments you might have.

And finally, I hate doing this to you but ...

Disclaimer: I've done my best to ensure that the information presented here is accurate but you should confirm for yourself before relying on this information for your financial decisions. It is always best to consult a qualified tax or investment professional to see if the ideas here would be appropriate for your personal financial situation.

This article is part of the Personal Finance 101 series.

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Comments

Fantastic article, thanks

Fantastic article, thanks very much for writing it. I was curious about eligible dividends as well and am pleasantly surprised they have such favorable tax treatment.

Peter's picture

You're welcome! Thanks for

You're welcome! Thanks for visiting and taking the time to leave a comment. Yes, the dividend tax credit is a very nice treat at tax time if you can take advantage of it.

So far I have just finished

So far I have just finished this first page and intend to come back and read your entire site. So informative and in laymen terms that don't put you to sleep (my accountant comes to mind .... zzzz's). Great you can write a way that will hold a readers interest. Most people avoid this subject for two main reasons; confusion and boredom.
You have simplified extremely well while composing in a very appealing way. I plan to pass this site along to all I think need the advice. Hmmmmm ..... almost everyone I know....lol. You should get a book in the works ;-) Hope you keep up with the great advice in the future!!

Peter's picture

Hi Neil! Thank you so much

Hi Neil! Thank you so much for leaving such an encouraging message. I'll do my best to keep writing interesting material for you and your friends. I must say though, feedback like this makes it a whole lot easier! I'm glad you enjoyed the article and feel free to let me know if you would like any other topics covered.

Very good! You may want to

Very good!
You may want to add a brief on RRSP's in the Income and Taxes section and a new section on investment vehicles such as RRSP's and the forthcoming IFSA.

I think you mean work

I think you mean work 'clothes' not cloths.

Peter's picture

Thanks for the suggestion

Thanks for the suggestion about adding some information about RRSPs. I'll see what I can do. Also, once the 2008 budget becomes law, I plan on doing a more detailed examination of the TFSA and RRSP together.

After being read over 1700 times, someone finally noticed that mistake! I've fixed it now. Thank you for pointing it out.

Peter

Nicely done. Any chance of

Nicely done.
Any chance of expanding on the income sharing with your spouse.
Harry

Excellent lesson - - another

Excellent lesson - - another source of after tax $ I like is the new sharing of pension income with my wife! even better than my dividends!

I AM PRETTY NEW IN CANADA SO

I AM PRETTY NEW IN CANADA SO YOU CAN IMAGINE WHAT A GREAT HELP YOU HAVE GIVEN ME. THANKS A LOT FOR A WELL DONE JOB.

Hey.. I was wondering if I

Hey.. I was wondering if I made approx 35,000 annually, and dont have any expenses to deduct. How much would my return be in Toronto, ON

Great info...

Great info...

Could you talk about taking

Could you talk about taking dividends from my limited company. I'm told by a friend , my spouse and I can take 35000.00 each in dividends tax free each year. Is this true? If so how?

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