What Do All These Tax Words Mean? Basic Tax Terminology

Tax terminology can be overwhelming. When I first started my career in tax, it was like trying to learn another language all-together. I kept annoying my boss by asking him to explain every single word that was coming out of his mouth. I totally get it. Tax is complicated. It's like working with a lawyer and reading legal definitions and terms, which in a way, it actually is! Tax terminology is 100% based on law. It's all based on legal code and government regulations, so if you're feeling overwhelmed, know that it really is that complicated. That being said, I hope I can help you understand some basic tax terminology to help you navigate conversations with your tax advisor.

Why do I have to pay taxes?

Have you ever wondered how the government gets money to make new roads, provide free healthcare or fund military efforts? No, they don't just pluck money off magical money trees. Instead, the government gets that money from taxes. Taxes are money that everyone—whether you're working, buying things, or even just living in a community—contributes to help pay for services and projects that benefit all of us in a country. We pay taxes to the government so that the government can fund and pay for things that they need to buy or keep running. For example, when you buy a product, a small portion of the price might go to the government as a sales tax, which helps fund things like roads, schools, and parks. Similarly, if you work, a portion of what you earn is taken as income tax to support services like healthcare, public safety, and infrastructure. In essence, taxes are a way for society to pool resources so that everyone can enjoy the benefits of shared services and a well-maintained community.

Income

Income is the money that you earned whether that is through salary, wages, contracts, businesses, etc. In terms of paying taxes, income is what income tax is calculated on. Often the word before the word "Tax" denotes what type of tax it is (e.g. capital gains tax, pineapple tax, sales tax, etc.) The government takes a percentage of the value of whatever income they are taxing as taxes. As an example. if you made $100,000 in income in one year, and the government wants 10% of your income as income tax, they will recieve $10,000 ($100,000 multiplied by 10%) of your money and you will be left with $90,000.

Deduction (a.k.a Tax Deduction)

A tax deduction is a subtraction from income (money you earn) that ultimately lowers your taxes. Deductions often stem from expenses (money you spend) such as business expenses, investment expenses or tuition, but can also include negative income items such as capital losses which are subtracted from capital gains. Example: If you earn investment income of $10,000 in a year, but have investment expenses of $2,000, you will receive a deduction of $2,000 for the investment expenses and the net investment income is $8,000. Note: "Net" just means you are adding and subtracting everything under the same category together. Example: Net income is adding all income and subtracting all expenses, net profit is adding all the profits and subtracting any losses.

Tax Credit

A tax credit is also a subtraction, but instead of it being a subtraction from your income, it's a subtraction from your taxes and directly reduces the amount of tax you owe, often on a dollar-for-dollar basis. Example: If you qualify for a $500 education tax credit, your total tax bill is reduced by $500.

Capital Gain & Capital Loss

Capital gain is just the tax term for profit. Capital gains are the profits made from sales. For example, I bought a chair for $50 and then resold it to my uncle for $60, therefore I made a profit of $10 or in other words, a capital gain of $10. Capital losses are the opposite - instead of profits, they are losses. If I sold the chair to my uncle for $40 instead of $60, I would have made a capital loss of $10 ($50-$40). Capital gains generally refer to profits you made by selling stocks or investments, but can include anything such as cars, houses or businesses.

Tax Bracket

So now you understand what income is and what taxes are. While it would be nice for us to have only 1 tax and 1 tax rate to keep things simple, governments just don't do that. If the government wants to tax people who earn more at higher tax rates, they need to create tax brackets. Tax brackets are just buckets used to categorize who should be taxed at what tax rate. As an example, the government might say that those who earn over $1M are taxed at 50% and those who earn $1M or less are taxed at 20%. This helps the government collect more money from those who are rich. In the simplified example, the government created 2 tax brackets - a 20% tax bracket for those earning $0-$1M and a 50% tax bracket for those earning $1,000,000+. The real world is actually a little more complicated. In Canada and the US, we have progressive tax brackets - this means that we don't tax based off your total income, rather - parts of your income are taxed at different tax rates. If we use the above tax brackets under the progressive tax brackets, the tax brackets would instead read as: any income up to $1M is taxed at 20%, and then any remaining income is taxed at 50%. If you earned $3M, the first $1M will be taxed at 10% and then the remaining $2M is taxed at 50%. The total tax would be $1M x 20% + $2M * 50% = $1.2M in taxes. The 2024 highest federal Canadian tax bracket is: 33% on the portion of income over $253,414.

Withholding (a.k.a Tax Withholding)

Withholding refers to any amount of money that is taken from income before the actual tax is due. I.e., income is withheld from you as taxes paid to the government. You can think of it like pre-paying taxes. The reason for this is: governments don't want to wait until the end of each year to collect all of your taxes, so what they often do is make your employer take a portion of your income as taxes throughout the year. Often your employer will subtract a portion of your paycheck and send it to the government each pay period. At the end, on your tax return, we will total all the withholdings and subtract them from your calculated tax. E.g. (continuing from the previous example), if you made $3M in income and the tax calculated was $1.2M, but your employer took out $90,000 of your paycheck as withholdings each month ($1,080,000 for the year), on your tax return, it will reflect that you already pre-paid tax of $1,080,000 ($90,000 * 12 months) for the year and your remaining tax balance is $120,000 ($1.2M-$1,080,000). Withholdings are not only limited to your employment income, but can also apply to capital gains, dividend income, business income, etc.

Tax Refund or Tax Balance Due

A tax refund is the amount returned to you when the total tax you’ve paid during the year exceeds your actual tax obligation. Tax balance is the inverse. If you haven't paid enough tax (or not enough income was withheld as taxes) during the year compared to what you owe to the government, you have a tax balance due. In the previous example, we showed that the tax withholdings were less than the actual tax obligation so there was a remaining $120,000 tax balance. However, if the tax withholdings were increased from $90,000 to $200,000, there would be a tax refund of $1.2M ($200,000 * 12 months -$1.2M) that the government would have to pay back to you.

Should you need help with your taxes, feel free to contact us for a free tax consultation.