Understanding Income Tax in Canada: The Basics You Need to Know

Max Shabalov here and welcome to Financial Literacy Canada podcast. When people think about income tax, they often think about tax filing season. But understanding how taxes actually work is one of the most important parts of building wealth. Taxes influence where we save and how we invest. My guest today is Amanda Doucette, a tax lawyer, TEP and the host of the Tax Cheek Podcast.

In our conversation, Amanda breaks down the fundamentals of Canada's tax system, what taxable income really means, how marginal tax rates work and why understanding these basics help you make smarter use of registered accounts like RRSP, TFSA, RESP and FHSA. Amanda Dusset, welcome to the show.

Thank you so much for having me. I'm excited to be here.

So you're a tax lawyer that helps business owners structure their business to ensure compliance with relevant tax laws. But you also have a great podcast about tax in which you explain serious tax topics in a clear way. And you believe that every Canadian deserves to understand the foundations of our income tax system. Why is it important for people to know how income tax works?

Well, think income tax impacts every aspect of your life. And from the moment you get out of bed in the morning, there's some tax consequence to most things that you're touching or being a part of. And it's such a huge piece of the public policy that underlies our government and how our systems work. It's not hard to learn and it's actually kind of fun. And so one of the things I've been trying to do is to encourage people to just dip their toe in and learn a little bit because it starts to impact the way that you walk through your day and the conversations that you have.

It's not just cool conversation for the elevator or the cocktail party, but it also impacts how you interact with your advisors and the questions that you ask. So everyone deserves to know this and it can actually be kind of fun to learn.

So when we pay our income tax there is federal and provincial income tax and we have progressive tax system for both federal and provincial. But how does the progressive system actually work?

So in Canada to start with Canadians are taxed based on their residency. So if you're a Canadian resident, you're taxed on your worldwide income. And if that income is also taxed in another country, there's all of these treaties or agreements between various countries that try to avoid you being double taxed, although it doesn't always work perfectly. If you're not a resident of Canada, you can still be subject to Canadian tax if you have employment income in this country or if you're carrying on a business in the country or if you have capital gains because you've owned property that you've bought or sold in this country. So you can still be taxed here even if you're not a resident here. And the basis of our taxation system, as you mentioned, is this concept of marginal tax rates or like a progressive tax rate system, and the idea behind that is that it's not a flat rate of tax. It's not like, okay, this year I made $50,000 so I'm going to be taxed 20% on that amount. Instead, marginal tax rates create brackets, So if you're making between $0 and $30,000 you're taxed at a certain rate, and then every dollar you earn above $30,000 for example is taxed at a new rate until we hit the top of the next bracket. And there are a set of brackets federally and there are a set of brackets provincially. And so when you file your taxes at the end of the year, you'll notice that there's actually two separate calculations that happen. You have to calculate how much tax you owe based on the provincial marginal rates, but also how much you owe on the federal marginal rates. And if anyone was listening to the federal budget that came out here just recently, there was lots of talk about the reduction to the lowest marginal tax rate federally. So the government has committed to lowering that lowest rate, the first bracket, that as opposed to being required to pay 15% tax on that amount, They're lowering it to 14.5% in 2025 and 14% in 2026. And the other thing that they did, which you might have heard about on the news, is that they also went and increased the tax credits that you get that accompany those marginal rates. They increased them to make sure you were still going to get the full maximum benefit. And I know we're going to talk about credits later, but those two things are actually connected. So marginal rates are important because it's, we hear a lot of things in the news about, oh no, now I've tipped over into the next tax bracket so I'm paying so much more tax. Well no, once you tip over and you make that extra dollar or that extra $2 that puts you in the next tax bracket, Only that extra dollar or $2 is taxed at the highest amount or the higher amount, not the whole thing. So it's kind of like looking at a set of steps going upstairs.

Right, so you're always better off earning higher income.

You are except the higher of course the income you get at a certain point, each dollar that you're making at a certain point, you're going to take home less of it. So depending on what your relationship is with money and how you feel about that, the first dollar you earn you're going to take more of that dollar home than the last dollar that you earn.

Right. So that's important to highlight because some people misunderstand how brackets work. Some people think if they hit the next tax bracket their total after tax income would be smaller. But actually that's not the case. Your after tax will always be higher if you earn more. But now moving on to the types of income. What are they and could you break down the most common ones?

So the way that our Canadian system works is that every dollar that you receive has to fall into a bucket or a category, a source of income. And there are certain sources of income in Canada that are not taxable at all. An example of that is if you receive an inheritance from someone in Canada that's not taxable. If you win the lottery, that's not taxable here. Those sorts of things, but most other types of income are taxable. The main one that we usually talk about is employment income. So the idea that if you work for a company and you receive a wage at the end of the month, typically that income is coming to you as employment income and likely you're going to see on your monthly pay stub that there have already been certain pieces of the tax that have been remitted to the federal government for you. So you're receiving kind of like a net amount, but that's this concept of employment income. You can also receive business income, and so if you're running a business or if you're an independent contractor or in one of those types of arrangements, you might be receiving income that relates to a business that you're running. And when you receive that type of income, there are certain deductions that are available to you if you fall into certain categories. And business income from a policy perspective has traditionally been treated favorably by the federal government, in that there are certain perks such as lower tax rates that might be available, increased levels of deductions, some flexibility when you're buying or selling interest. Those things have changed in the last ten years or so to not be as beneficial as they used to, but this concept of trying to foster business in the country usually leads itself to having some advantages, to having that type of income. Then there's also investment income, and that's like the passive income. It's the you've put money somewhere and you're kind of just sitting back and it's just doing its thing, you're not having to do anything actively with it. So this is like your investment income or if you maybe have like a rental property and you've hired someone else to manage it and you have some rental income coming in, those types of things. The investment income that you receive is typically taxed at a higher rate regardless of whether you receive that as a person or you receive that as a corporation. Typically it does not have the same benefits that business income does, except in certain circumstances. So it's not so much that when you think of what comes into your pocket at the end of the year that you're wanting to categorize it, but if you ever look at your tax return, there is a form of categorization of those different sources of income and how they each get taxed is slightly different.

Let's talk about the ways you can reduce your employment income. So there are tax credits and tax deductions. Let's start with tax credits. So what are they?

Okay, so it's great that you're talking about this credits versus deductions, because I think people get a little confused sometimes of the difference between the two. So when you think about filing your tax return, you're first starting by putting in all of the income that you've received, You're eventually going to get to a number that we call your taxable income. This is the income, the starting point upon which you could be taxed. When you're trying to get to that number, you have to start thinking about tax credits, and that's an amount of money that gets deducted from the amount of tax that you owe. A tax credit doesn't get deducted from the amount of income you earn. A tax credit comes off of the amount of tax you owe, and the amount of the credit is typically the same regardless of how much money you owe in taxes. There are kind of a couple of different types of credits that you'll hear about. There's a credit called a non refundable credit, and that can only be used against the tax that you owe. So if you don't owe any taxes, you can't take advantage of the credit. So examples of those are things like your basic personal amount. We always talk about how everyone gets this basic personal non refundable tax credit that's just available to them. Well, if you don't owe anything, there's nothing to use that credit on and it doesn't become available to you. Similarly, if you make a charitable donation and you want to deduct that donation receipt or use that credit, it doesn't become available to you unless you have tax that you can offset. The other type of tax credit is what's called a refundable tax credit, and these are credits that you get regardless of whether you owe tax or not. But in order to qualify for them and in order to claim them, you have to file a tax return. And so if you think about some of the rhetoric that's been happening in the news lately about this concept of sort of automatic filing of tax returns in Canada, One of the main reasons why they're trying to do that is there's an entire group of the population that qualifies for these refundable tax credits, but is not filing tax returns. And so they're trying to get benefits out to a lower income population to try to provide some support. Examples of those are like the GST credit, right, or the working income tax benefit, those types of things. So those are the two different types of credits you typically see.

Perfect. And now tax deductions, what are they?

So a tax deduction operates to reduce your total income. So that as a result, if you reduce your income, there's a smaller dollar number that's being taxed. So it operates at a different part of the tax return. So a deduction that you'll see is things like a deduction for RRSP contributions. An example of a deduction would be some of these business expenses that you're trying to write off. The purpose of using those is to get your income number down, so you have a smaller number that is taxed versus the credit, like we talked about earlier, where it's really about can we reduce the amount of tax or otherwise just get a perk by getting this credit even if we don't have tax to pay.

Great Amanda. So we discussed tax brackets and how deductions work, and these are fundamental basics to understand the true value of registered accounts. And registered accounts, they offer certain tax advantages and you already mentioned RRSP, so let's begin with it. How does RRSP work?

Good. So I think an RRSP is the thing that most of us are most familiar with and it's a vehicle that probably a lot of our parents use. An RRSP is not an investment. An RRSP is an investment vehicle. And so think of an RRSP as a box and you can put a bunch of stuff in the box. There are many different types of investments and investment accounts that you can have in that box. You can have mutual funds, equities, bonds, savings accounts, all of those things. But it's an investment vehicle and it was created back in 1957 in Canada, actually, and an RRSP stands for Registered Retirement Savings Plan. These plans are overseen by CRA and there's all these rules, of course, because every time you have a perk, there has to be a rule that sets things like annual contribution limits, talks about the timing of a contribution. The concept of an RRSP is that you can put money into this vehicle, and when you put money into the vehicle, you get a tax deduction. So that's great if you have a lot of income and you're trying to reduce that income so you pay less tax. An RRSP deduction is a great way of doing that. The RRSP itself, that vehicle, the growth in there, it grows and grows and you don't have a tax consequence until you go to pull it out. And if you go to pull the RRSP out, there's a tax consequence. But in the meantime, you get the deduction going in and you get the growth that builds, while the RRSP is in, is in place. The thing about an RRSP is that there are, there are limits each year to what you can put in, and the limit is the lesser for 2025 of 32,004 hundred and ninety or 18% of your earned income in the previous year. There are certain permissions to carry forward our RSP room from a previous year. If you haven't used it, you can actually carry it forward a number of years, which is great. And this dollar limit for what you can put in each year is indexed to annual wage growth. So you've kind of got to look at the number each year to see what's available. One of the things about RRSPs that sometimes people forget is you need to have earned income to create contribution room. And so if you're being paid, for example, solely by dividends, and you have no other earned income, you may not earn anything to be able to contribute to an RRSP or increase your room for the year. So RRSPs are a cool vehicle. Of course, once you turn 71, you can no longer have an RRSP. They convert to something called a RRIF or a Registered Retirement Income Fund. And at that point in time, there's this forced mandatory amount that needs to get pulled out on an annual basis. And of course you're taxed on that. The idea being the government wants you to start whittling down those funds as you head into retirement. So that's my sort of summary of an RRSP.

So basically RRSP is like a deal with the government. Listen, I don't want you to tax me right now, deduct that amount, and later when I'm retired, I will withdraw this money, but I will be paying less tax because I will be at a lower tax bracket because I don't earn so much when I'm retired. Is that the correct summary?

That would be the intended plan, yes. Then do you want to move to TFSAs?

Yeah, sure. What's the difference between those two?

A TFSA stands for a tax free savings account, we all know what we're talking about. These were introduced in Canada a bit more recently, guess. I mean not that recently, 2009. And there's some similarities to this concept of an RRSP because there's annual contribution limits. You can get in trouble if you go over those limits, there's penalties, etc. But the difference between a TFSA and RRSP is with a TFSA, there is no deduction at the time that you contribute funds into it, so you don't get that immediate tax deduction. The growth in the TFSA though continues on a tax free basis, so that's really fantastic. Withdrawals from a TFSA are taxed, So that's the big perk. You don't get the perk at the front end, you kind of get it at the back end and you have to pay attention to these annual limits. There's an amount of carry forward that's available. So for example, currently in 2025, there's a $7,000 limit to contribute. If you had never contributed to a TFSA since the time it was created, I think your cumulative limit is like $102,000 or something like that. But they're kind of cool concept because when we think about saving money, the alternative could be that we open a savings account at a bank. But if we open a savings account and it earns interest and the interest is sufficient, each year we're going to get a tax slip that's going to set out that interest income and we have to pay tax on it and report it. A TFSA is kind of like a special type of savings account where we can earn interest but we're not taxed on that interest.

So that's a really great account for investing.

It is. And it's also a nice account if you're not trying to hold funds, you know, if you might need access to funds fairly easily, because I mean with an RRSP, it's great you get this deduction, but it somewhat gets locked in, right? If you start pulling it out, you're going to be taxed. With a TFSA, you don't get the benefit in the front end, but you can throw it in there. You can make some interest income, not be taxed on it. And then if you need to pull it out, there's a bit more flexibility to pulling it out. And then there's no tax consequence. So it depends what you're using the money for or what your ultimate investment strategy is.

And there's another account that's pretty new FHSA for those who never had home. And I believe FHSA has the advantages of RSSP and TFSA, like it's the best of two worlds. Is that correct? How does this work?

You're absolutely correct. So an is the first home savings account, and it's kind of like if you took an RRSP and a TFSA and you smush them together, you can get an FHFA. And so the contributions that you make into this type of account, they're deductible, just like an RRSP, but similar to a TFSA, the investments in your first home savings account, they grow tax free. There are annual contribution limits, which we're all familiar with now. The limit for 2025, the annual limit is 8,000. You can carry forward unused limits up to a maximum of 8,000 in a single year. And what these accounts are intended to be for is that you're going to put money into them in order to grow your funds and your money to then pull it out to use for the purchase of your first home. So you can open these accounts through banks, through credit unions, trust companies. The accounts can be open for a maximum of fifteen years, so they're not intended to be long term savings vehicles. They're intended to be used for a specific purpose, and when you're withdrawing money from them, the only way you're going to get that non taxable treatment is if you're pulling out money for a down payment for a home. And there's all this eligibility criteria. So you have to be a Canadian resident. You have to be at least 18 years of age, and you have to be a first time home buyer. So you can't have lived previously in a home that you owned or that your spouse or common law partner owned in the current year or the four preceding years. So you just need to make sure that you actually qualify and when you're opening up that type of an account.

Nice. So FHSA is a really powerful tool for first home buyers. And I'll also quickly mention to the listeners that there is another thing called home buyers plan in which you can use funds from your RSP as a down payment for your first home. But then later you would need to repay those funds back to your own RSP. So if you're considering to purchase first home, so you can also have a look at this plan and use RSP as well. But now moving on to the last registered account that we'll discuss today RESP. If you have kids or plan to have kids, you must know about it. Amanda, how does RESP work?

So RESPs are registered education savings plans. So many acronyms today, and these are a type of plan that you can use to save money for post secondary education for your child. And what's really cool about these is that there's a matching contribution from the government, which is what makes these plans sometimes more attractive than just throwing money in a savings account or some other investment vehicle to try to gather up funds for your child. Of course, though, with that perk, there's requirements and there's terms that come along with your RESP contract. So in an RESP contract, let's say I'm going to open one for my child. I would be called the subscriber. This is the person who created the account. I have control over this account to put money in and take it out. And then I'm naming a beneficiary. So I'm naming typically my child, my children, or grandchildren. We see people open these for grandchildren. The key with RESPs is that there's specific uses for them at the time that you're withdrawing. So some educational programs may not fall within the list of approved educational programming. I mean, you know, typical post secondary education like a university or technical schools, usually do qualify. But sometimes if someone's taking a certificate program or something that's not from a registered post secondary education institution, it may not qualify. And that's the one thing because if you're buying this for your children and they're like two years old, you don't know what they're going to do in the future. But there's an intended purpose for why this is growing. The other thing that you need to remember about RESP if you're a parent and you're listening to this, is you want to give some thought to what you're doing with your estate planning and RESPs because an RESP is your asset. It is not like an RRSP or a TFSA where you can designate beneficiaries and it can fall outside of your account or your estate. Technically an RESP is your asset and it falls into your estate when you die. And so you want to think about who's taking over this once you're gone. Do you have directions for them in terms of continuing contributions, when they can withdraw, etc. So if you're listening to this and you're also doing your estate planning, maybe check-in to see what your RESP says and have a conversation with your advisor about that.

And Amanda, to my understanding RESP is also taxed but it is taxed on a child, right, on the beneficiary. So when they study, when you withdraw the money from RSP, the child will be in a lower tax bracket. Therefore you will pay less taxes. Is that correct?

You are correct. You are correct. And of course the growth in the meantime, it occurs on a tax free basis.

That's fantastic. And what is the amount there to maximize the government grant contribution?

I believe it's a lifetime maximum of 7,200 per beneficiary because it's a match of 20% on the first 2,500 that you're contributing annually. So it's not a nice, clean calculation. It's not that every dollar that you put in a dollar is contributed by the government. It's kind of a fractional portion, and there's different types of grants depending on your net income of your family. So there's your base grant from the government of this 20% matching on the first 2,500 annually, but then there are some additional grants that might be available depending on the net income of your family, where you might be able to get an additional 10 or 20% grant on certain amounts contributed. And then there's also some other bonds if your kids fit into certain categories. So this is something that if you're going to your institution to set one up, can they can tell you based on your specific circumstance what the matching contribution will be and what the limits are for your circumstance.

Perfect. When it comes to prioritization between those four accounts RRSP, TFSA, RESP, FHSA, I know everyone's situation is different, but how would prioritization look like?

Well, depends what your goals are. So if your goal was that you want to buy a home and you're going to buy a home in the next five years, maybe your priority is the first home savings account, right? If your priority is my income is too high and I'm trying to reduce it because I'm paying too much tax, your priority might be an RRSP if you have appropriate income to get the contribution limit. If you've already maxed all that out and you're just looking for a place to store extra funds and not have that interest be taxed, a TFSA may be your priority. Or if you're looking for funds you can easily access, a TFSA may be your priority. If you have young kids and you're looking to build some savings vehicles for them for future education, an RESP is going to be your priority. I find typically when I mean, I'm not an investment advisor, but when I'm working with clients on their tax and estate planning, they usually have a mix of these things because they have more than one goal. And so I think like anything in life, you don't always want to put all of your eggs in one basket and what you choose to contribute to in one year might be different in the next year if your goals change.

Right. And Amanda, we talked a lot about taxes and different accounts, but when it comes to tax, where does it go? How government decides what amount goes where?

So I mean the purpose of taxation is to collect money for social programming typically, right? I mean that's one of the main purposes of it. So our healthcare systems, school systems, social services systems, keep our government systems running. So each year when we receive the federal budget, like just happened recently, they talk about how these various funds are allocated and where the income is coming from. A large source of income for this is taxation that they receive from the citizens. And so you will often be able to get an idea of the underlying policy of a government by looking at what they're taxing. So based on what they're taxing, it tells you what they want to foster in the country and what they want to stop. And then you look at where they're spending it. And so they're spending it on various different government programs that is supposed to be shared by you know all Canadians. So it's kind of like pooling funds for the good of the greater country.

Well Amanda this has been a great conversation. Where can people go to learn more about you and your work?

So my podcast is called The Tax Chick Podcast and I have a website www.thetaxchick.ca which has information on the podcast. It has a whole bunch of free blog posts if you're looking for something in writing and talks a bit about me. I am a full time lawyer. I'm one of in the management team of a small boutique firm here in Saskatoon. The podcast is kind of like what I do in my spare time. And so if you're curious to learn more about tax, I encourage you to check out that website. I'm also on Instagram at tax. Chick. And I'm also on LinkedIn if you want to connect with me there at Amanda Dussett.

Well, fantastic. Thanks for your time. It's been a pleasure.

Thank you so much for having me.