In Canada we have 2 main ways we can pay less tax. This is through credits and deductions.
For most people they just know that both work to reduce the amount of tax you pay. But if you have ever wondered how they work, how they differ from each other, or which is better then keep reading.
How Tax Deductions Work
When you add a tax deduction to your return it reduces your taxable income dollar for dollar. Common deductions are child care, employment expenses like the working from home deduction, and RRSP contributions.
Let's say that you have 2 kids and they are in daycare while you work during the day. Your salary was $60,000 in 2023 and you paid $20,000 for childcare fees during the year.
Since you have a $20,000 deduction your taxable income (the amount of money you have to pay taxes on) is only $40,000 instead of $20,000.
Total income - deductions = taxable income
$60,000 - $20,000 = $40,000
Because deductions directly reduce how much income you have to pay taxes on they can even be used to bump you down into a lower tax bracket. A common example of this is someone using their RRSP contributions to go from a 26% tax rate to a 20.5 or even a 15% tax rate.
How Tax Credits Work
A tax credit involves a bit more math than a deduction but it works by reducing your tax payable.
Federal tax credits get added together then multiplied by 15% since that is our federal tax credit rate. That number gets subtracted directly from how much federal tax you have to pay.
The same process happens for provincial/territorial tax credits. These credits get added together and then multiplied by your provincial or territorial tax credit rate which is the lowest tax bracket in your province.territory. This then gets subtracted from your provincial/territorial tax payable.
Which is More Valuable on a Tax Return
This is a great question and one with a more complex answer. In general the more tax credits and/or deductions you have the less tax you have to pay.
However, in the tax community some people have the opinion that tax credits are more valuable because they are directly subtracted from your tax payable.
Although, tax deductions give you a dollar for dollar impact instead of only 15% and can bump you into a lower tax bracket.
See you next week,
Laura
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