Tax credits are amounts that directly offset tax payable, while tax deductions are amounts which are used to offset and reduce a taxpayer’s income.
To understand how deductions and tax credits interact with the value of money coming out of your pocket, it is helpful to consider the full process of recognizing income and paying tax, from start to finish.
The calculation begins with one’s income, which is made up of income from sources listed in the Income Tax Act. For Canadians this includes all one’s worldwide income from sources.
In turn the taxpayer deducts expenses incurred to earn income. This will cause the taxpayer to arrive at their taxable income. Taxable income is then multiplied by the taxpayer’s relevant tax rate to arrive at their tax payable.
Once a taxpayer has arrived at their tax payable, they may then deduct the applicable tax credits. Once this deduction is made, a taxpayer arrives at their full tax liability for a given year.
A taxpayer earns $50,000. This is their total worldwide income from all sources.
This taxpayer has $10,000 of tax deductions, which leaves them with $40,000 of Taxable Income (the tax deductions offset the income).
If the taxpayer is in a 25% tax bracket, they will have to pay $10,000 of tax.
In turn, if the taxpayer has $2,000 of tax credits, they will have to pay $8,000 of tax since the $2,000 of tax credits are used to offset the $10,000 of tax which would otherwise have to be paid.
The Income Tax Act provides for various tax credits. These include: a basic personal credit, a dependant spouses credit, an equivalent to spouse credit, a dependant minor credit, a family tax cut, and charitable tax credits. With regard to charitable tax credits, they are calculated by multiplying the first $200 donated to a registered charity by the lowest federal marginal tax rate, and an amount over $200 by the highest federal marginal tax rate. These amounts are added together, and the same process is completed by applying provincial rates. The total of this gives the taxpayer an amount they can offset against their tax payable.
If a tax credit exceeds the taxpayer’s payable tax, the government makes a payment to the taxpayer equal to the difference – only if the credit is “refundable.” If the credit is non-refundable and this occurs, then the Government does not make a payment.
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