It is a common source of dread when that time of year draws near and you realize you need to fill in your tax return. Because of this, it is something that is often left to the last minute or outsourced to an accountant as a way to avoid it altogether.
There are a lot of federal, provincial, and territorial tax deductions and tax credits you can apply for during tax season too, which adds to the confusion. This means that more often than not savings that could have been made from tax deductions and tax credits are missed, and you end up overpaying your taxes.
Deciphering deductions and tax credits can be troublesome and you would be forgiven for not really knowing the difference between the two. To help we will explore some important fundamental differences that you should be aware of, and how each impacts your tax return.
Federal tax vs provincial tax
As we mentioned, there are federal rates of income tax and levels of deductions and tax credits and there are also provincial rates and territorial rates too.
For this article, and the examples we will be using, we will focus on federal rates to keep things simple. It is important, however, to be aware that there are differences from province to province, and if you want to have a deeper look into what the rates are for where you live you could start by looking here.
What is a tax deduction?
First things first – tax deductions.
Tax deductions are used to reduce the amount of your taxable income. You subtract these deductions from your total income before calculating your taxable income.
You can claim deductions on a number of items including your RRSP contributions, child care expenses, you can even claim deductions for being a northern resident to name a few. If you want to get a better understanding of what tax deductions you can apply for having a look at our article here.
Let’s break this down into an example to help clarify:
If you earn $80,000 in a year, and you have deductions equalling $10,000 (from your RRSP contributions, medical expenses, child care expenses, etc), then your taxable income will be reduced to $70,000.
$80,000 – $10,000 = $70,000.
We will explore what a difference this makes to your tax liability below.
What is a tax credit?
Tax credits, on the other hand, are amounts you can claim back to reduce the amount of income tax you pay.
This may sound the same as a tax deduction but the difference is that it reduces the amount of tax you owe, not your taxable income.
The amount that your tax credit reduces your income tax is calculated based on the lowest federal tax bracket of 15%. So if you are eligible for a $10,000 tax credit then you will be able to reduce your tax by $1,500 (15% of $10,000 is $1,500).
You should also be aware that you can get refundable and non-refundable tax credits.
Refundable tax credits reduce the amount of taxes you owe. If those taxes are reduced below zero then you will receive the rest of the tax credit as a refund. For example, your refundable tax credit reduction is $1,500, but your tax is only $1,000. You will receive the $500 as a tax refund.
Non-refundable tax credits also reduce the amount of taxes you owe, but if your non-refundable tax credit is worth more than your tax then you won’t receive anything. For example, again your tax is $1,000 and your non-refundable tax credit is $1,500. In this instance, you would pay zero tax and not receive anything as a refund.
Tax deductions vary based on income bracket, tax credits don’t!
A key difference to note is that tax deductions are variable dependent on your income, and the tax bracket you would fall into, whereas a tax credit would be the same whether you’re in the lowest tax bracket or the highest.
How does a tax deduction or tax credit impact your tax?
If after all of that it still feels a little unclear as to how a tax deduction and a tax credit affect your final income tax amount differently, let’s look at an example to clarify:
Your total income is $80,000 a year. Without any deductions your federal income tax would be $13,703.9, which breaks down as:
Your first $49,020 at 15% – $7,353
Your remaining $30,980 at 20.5% – $6,350.9
If you had $10,000 worth of tax deductions you could make this would bring your taxable income down to $70,000, which would bring your income tax down to $11,653.9. This breaks down as:
Your first $49,020 at 15% – $7,353
Your remaining $20,980 at 20.5% – $4,300.9
This is a saving of $2,050 in taxes for the year.
As mentioned above, in order to work out our tax credit impact we need to do a little extra step. Any amount that is eligible for a tax credit will generally create a federal tax saving. This tax saving is based on the lowest tax bracket of 15%. Remember, this is the same regardless of what your income is.
So, if you have a tax credit amount of $10,000 then your actual tax credit that you can reduce your income tax by would be $1,500 (15% of $10,000).
Using the same example above, your income is $80,000 and your income tax is $13,703.9.
As we are looking at a tax credit here, the $1,500 is subtracted from the income tax amount, so the total tax you would owe would be $12,203.9.
As you can tell, tax deductions can be a lot more powerful at reducing your tax bill when your earning are in the higher tax brackets.
Are tax deductions or tax credits better for your taxes?
There are plenty of federal, provincial, and territorial deductions and tax credits you can apply for that will dramatically reduce your taxes, and maybe even result in a tax refund.
The answer to this question, which is better, depends on your income, where you live, and what expenses you have paid for during the year.
Simply put, both are equally important to be aware of, and taking some time to understand what you can claim for both will help you save money from the taxman.