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Individual Tax Series: Income Tax Deducted: Understanding Withholdings and How They Affect Your Tax Return
- Rylan Kaliel
- Sep 16
- 7 min read
Updated: Sep 22
Income tax deducted at source is a critical aspect of Canada’s tax system, ensuring that taxpayers contribute to their annual tax liability throughout the year. Whether you're an employee, pension recipient, or investor, understanding how income tax is withheld, reported, and reconciled can help you better manage your finances and avoid surprises at tax time. This blog will explain how income tax deductions work, how they impact your tax return, and strategies for optimizing withholdings.
What is Income Tax Deducted at Source?
Income tax deducted at source refers to the amounts automatically withheld from your income by your employer, pension provider, or financial institution. These withholdings serve as advance payments toward your total tax liability for the year. These were discussed briefly in our previous Taxes Payable blog, but let’s take a deeper dive to understand how these withholdings arise.
Common Sources of Tax Withholdings
The most common sources of income tax deducted at source include:
Employment Income (T4 Slip)
Employers deduct federal and provincial income tax from employee wages each pay period. Employment withholdings are typically calculated based on your completion of a TD1 Personal Tax Credits Return. The TD1 will determine what tax credits and other amounts you may be expected to receive in a year for purposes of determining the amount of your withholdings.
Once the TD1 has been completed, your tax withholdings for a pay period are calculated by determining your income for the pay period, estimating what this income would be for a full year, calculating what tax you’d have to pay for the full year, and then reducing this to what taxes you’d have to pay in the pay period. This can be a relatively complex process and may be easier to illustrate. Let’s assume that you get paid twice a month, on the 15th and the last day of the month. You made $2,000 this pay period, live in Alberta, and are only entitled to the basic personal amount, both federally and provincial and the Canada employment amount.
As we can seen in the above, we have to determine our estimated income for the year and then apply our tax rate and tax credits to these amounts. We also have to include CPP and EI (for a refresher on CPP and EI calculations, see our Basic Personal Amount blog post) to come up with our total taxes payable for the year. We then divide this amount by our number of periods in the year to determine what portion of these taxes we would have to pay in the period. The concept is that if your income remained the exact same all year, this taxes payable would be paid 24 times, resulting in the full taxes payable being paid by the end of the year.
Once we have calculated our estimated taxes payable, we can now also calculate how much we actually get paid. Let’s use the above assumptions and calculations and determine this.
The above notes that from the $2,000 we made for the period, we would subtract or taxes payable for the period to get our pay for the period. This is the amount you actually get to take home as cash from your employment. Often times you can review your pay stub to see these specific calculations, including detailed income tax, CPP, EI, and other deductions taken from your pay during the period.
Please recall that these calculations often come from the results of your TD1. The TD1 will lay out exactly what credits and other amounts you may be entitled to and may also illustrate whether you want increased or reduced withholdings. Note, while the TD1 can be used to reduce withholdings to a certain extent, this does not mean you can attempt to completely eliminate your withholdings. Your employer still has a responsibility to fairly calculate the appropriate withholdings and will not typically be able to reduce the withholdings beyond a reasonable amount.
While the calculations above can be extremely complicated, especially when you begin to factor in the marginal tax rates and specific amounts, there can be an easier way to determine how much your taxes and take home pay will be. The CRA’s payroll calculator can assist with these calculations. Other helpful tools could include Talent.com’s Income Tax Calculator, which not nearly as precise as the CRA’s payroll calculator, can be helpful for determining what your taxes and pay will be from a very high level.
Pension Income (T4A or T4A(P) Slip)
Tax is withheld from pension payments, including CPP and private pension plans. These withholdings differ from employment income as they are based on specific brackets of amounts withdrawn, as follows:
10% (5% in Quebec) on amounts up to $5,000
20% (10% in Quebec) on amounts exceeding $5,000, up to and including $15,000
30% (15% in Quebec) on amounts over $15,000.
These brackets operate very similarly to the marginal tax rate calculations, as was discussed in our Taxes Payable blog post. Let’s look at an example to illustrate this. Let’s assume that you are a resident of Alberta and are withdrawing $40,000 from your RRSP in the year. The withholding calculation would be determined as follows:
In the above calculation, the first $5,000 is taxed at 10%, the next $10,000 ($15,000 - $5,000) is taxed at 20%, and the final $25,000 ($40,000 - $15,000) is taxed at 30%. These are added together for a total tax withholding of $10,000.
Let’s now consider three separate withdrawals, the first is for $5,000, the second is for $15,000, and the third is for $20,000. These happen evenly throughout the year.
In the above calculation, we can see that as we withdraw amount during the year our withholding rate increases. This is because the withdrawals are tracked as a total, with the earlier withdrawals being withheld at a lower rate then later withdrawals that move us through the brackets. The final withdrawal is withheld entirely at 30%, the highest rate.
Now let’s look at the amount of cash actually received under each of these withdrawals.
As we can see we get more cash in hand on the first withdrawal due to this lower rate with an effective withholding rate of 10%. This increases to 23.33% (not quite 20% as part of the withholdings were withheld at the higher 30%) and then finally to 30%. This should be considered carefully as you withdraw pension amounts to understand that later withdrawals will have a higher withholding rate on them.
Investment Income (T5, T3, T5008 Slips)
Certain investment income sources may have tax withheld at source. This is more common with foreign investments, such as dividends being received from the US, but there can be some withholdings arising from Canadian investments as well. As these are rarer, we would suggest that you reach out to a tax professional in the case that you see any tax withholdings on your investments.
How Income Tax Withholdings Affect Your Tax Return
The amount of tax deducted at source is reported on your T4, T4A, or other tax slips and is credited toward your total tax payable for the year. When filing your return:
If too much tax was withheld, you will receive a tax refund.
If insufficient tax was withheld, you may have a balance owing and need to pay additional taxes.
This was discussed in great detail in our Taxes Payable blog post, please review this post for more details.
Adjusting Your Income Tax Withholdings
To optimize your tax withholdings and avoid large refunds or balances owing, you can:
Complete Form TD1: Employees can adjust the amount of tax withheld by submitting a revised TD1 form to their employer, reflecting additional deductions or credits.
Request Voluntary Withholdings: Pensioners and individuals with multiple income sources can request additional tax be withheld to prevent owing taxes at year-end.
Monitor Your Pay Stubs: Regularly reviewing tax withholdings on your pay stubs can help you identify discrepancies early.
It can be helpful to discuss these strategies with a tax professional ahead of proceeding to ensure the amounts are appropriate. As was discussed in our Taxes Payable blog post, large refunds may represent taxes that didn’t need to be paid during the year and could have been cash on hand, so are often best to avoid. As is discussed in our Tax Instalments blog post, having a large balance owing can result in instalments being payable, which can result large amounts of cash be paid each year and can be difficult to manage and avoid interest and penalties.
Special Considerations for Self-Employed Individuals
Self-employed individuals do not have tax deducted at source and must plan accordingly by:
Making quarterly tax instalments to the CRA to avoid penalties. These will be discussed in greater detail in our next blog post.
Keeping track of deductible business expenses to reduce taxable income.
Setting aside a percentage of earnings for taxes to prevent cash flow issues.
Note, it can be extremely important to estimate the taxes you may owe at the end of the year, especially if it is your first year in business or if your business has done exceptionally well during the year to ensure you have the right amount of cash set aside for your taxes. Further, as a self-employed individual, you will typically be required to pay not only the employee side of CPP and EI (as noted above in Employment Income (T4 Slip)), but also the employer side of CPP and EI, which could double the required tax paid for these amount. Plan carefully for what you expect your taxes will be and ensure you have amounts set aside to pay these.
Common Mistakes and How to Avoid Them
Mistakes related to income tax deducted include:
Not adjusting TD1 forms for additional deductions, resulting in excessive withholdings.
Relying on tax refunds as a savings plan, which could indicate overpayment of taxes throughout the year.
Failing to account for multiple income sources, leading to under-withholding and unexpected balances owing.
To avoid these errors:
Accurately complete your TD1 forms to reflect deductions and credits.
Adjust voluntary withholdings if needed to better match tax liability.
Regularly review tax withholdings throughout the year.
Summary
Income tax deducted at source plays a key role in ensuring taxpayers meet their annual tax obligations gradually throughout the year. Understanding how withholdings work, adjusting them when necessary, and planning ahead can help avoid surprises and ensure a smoother tax-filing experience.
Stay tuned for our next blog, where we will discuss the tax instalments, how they are calculated, payment due dates, and potential penalties and interest for not paying these instalments.
KLV Accounting, a Calgary-based accounting firm, is here to help. Contact us today to enhance your financial strategy, minimize your taxes, and drive business success! For a free consultation, call us at 403-679-3772 or email us at info@klvaccounting.ca.
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