Common misconceptions about taxes

Recently, I shared the results of an H&R Block study that suggests that Canadians do not know a lot about taxes despite the fact that it is the one thing we all have in common … we have to pay it.  From my experience, I agree with the study because I see it all the time.  I think taxes are really misunderstood so I thought I would share some of the common misconceptions I hear over and over again.

“I lose 50% or more to taxes.”

It’s nearly impossible for the average Canadian to really figure out how much tax they pay especially when you include all forms of tax from all three levels of government like sales taxes, import duties, excise taxes, gas tax, payroll tax, etc. The Fraser Institute in Canada tries to estimate this through their calculation of tax freedom day.  This is a theoretical date when the average Canadian family is released of its tax obligation for the year.  Tax freedom day has lead many people to believe 50% of their money goes to tax in some way shape or form.  In 2010, Tax Freedom day was June 3rd.  In theory this means we pay 42% in tax, not 50%.

But really, when it comes to income tax, we pay less tax than we think.  It’s critically important to understand the difference between marginal tax and average tax.

“I should have never taken that raise, I lost it all and more to taxes.”

This is a simple misunderstanding of Canada’s progressive tax system (marginal tax) where the more you earn the more opportunity you have to pay tax. The misconception is that moving into a higher marginal tax bracket will subject all your income to a higher tax rate – this is not the case. The truth is, only the income that is in the higher tax bracket is taxed at the higher rate.  All of the money you earned below the new tax bracket remains taxed at the lower rates. It’s so important to have an understanding of basic tax planning tidbits.

The bottom line is you should never, ever, ever turn down money!  Enjoy every pay increase you receive without tax worries and remember that those higher paycheques means more money in your pocket.

“My goal is to pay no tax!”

There is a simple solution to this goal.  Simply make no money and you will pay no tax.  The irony is that you should try to pay as much tax as possible because it means you are also keeping more money in your pocket.  Our progressive tax system still encourages people to make as much money as you can.  Generally you are not ‘penalized’ for making more money.  Sure you will pay more tax when you make more money but as I mentioned earlier “Never, ever, ever turn down money” because paying more tax also means more money in your pocket.

“I should have never bought RRSPs because they tax me when I take it out anyway.”

Quite often, this statement comes from those that are already retired who want or need to withdraw some money from their RRSPs. When you take money, you have to pay tax at your marginal tax rate, which means that if you want to spend a dollar, you need to take out at least a $1.33 to net a dollar. What retirees often forget is they got a tax deduction a long time ago when the money went into the RRSP. In other words, the government lent them money when they made the contribution. Although they have to pay that money back when the money is withdrawn, in most cases, they got a bigger deduction when they put the money in than the amount of tax they are paying when they take it out. For example if you put the money in while you were working an in a 36% marginal tax bracket and you take it out when you are in a 25% marginal tax bracket, you just made 11% in a return based on tax. This 11% is on top of any investment your return through investing. Sure, you might dislike the thought about paying 25% when you take it out but don’t lose sight of the benefit you got when the money went in.

If you understand the proper use of RRSPs, you will know that even though you pay tax when the money comes out, the RRSPs can still very much work in your advantage.

Do you know any other misconceptions about taxes?

Written by Jim Yih

Jim Yih is a Fee Only Advisor, Best Selling Author, and Financial Speaker on wealth, retirement and personal finance. Currently, Jim specializes in putting Financial Education programs into the workplace.For more information you can follow him on Twitter @JimYih or visit his other websites Group Benefits Online and Advisor Think Box.

Filed Under: Tax

5 Responses to Common misconceptions about taxes

  1. Thanks for explaining the that all I earned below the new tax bracket remains taxed at the lower rates. That is really good to know.

  2. I don’t know about Canada but here in the U.S., two things one must understand:

    1. The more you make, the less you pay – ever heard of loopholes?
    2. The less you make, the more you pay – never heard of loopholes?

    “The hardest thing in the world to understand is the income tax.” – Albert Einstein, physicist.

    Well! It may be connected to his theory of relativity but, being a physicist that he was, he didn’t think of the U.S. tax system in reverse.

    It would have been a lot easier for him if he understood the two things I mentioned above.

  3. I would disagree, our system is not very progressive at all. consider that our top income tax rate is near 50%, then add 13% hst if you choose to spend that money. then gas and alcohol are 40-50% tax, or propterty taxes if you buy a bigger property, one could lose 70% of extra income. certainly not an incentive. many go the other way to consulting to reduce or eliminate income taxes.

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