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TAXFlash News from IncomeTaxCanada.net
:: Lowering your taxable income can sometimes mean deferring your RRSP tax deduction to avoid changing tax brackets
:: A natural inclination of taxpayers when preparing their tax returns is to attempt to lower their taxable income by whatever legitimate means possible. Digging into their bag of tricks, taxpayers often use strategies consisting of income deferral, income splitting and making maximum use of available deductions and tax credits. This certainly seems like a logical approach – after all, a lower taxable income means lower taxes. True enough, but is this a path taxpayers should blindly follow? Perhaps not, if you keep the bigger picture in perspective. To help grasp the issue you need to develop a solid understanding of personal income tax brackets – what they mean, where they begin and where they end. In Canada, we have what is commonly referred to as a “progressive” tax system (some might argue “regressive” is more the word). What this means is that tax rates increase as income increases. Changes in tax rates don’t, however, occur with each dollar of income earned – rather tax rates stay constant within a range of income, changing to a higher rate only after income exceeds a stated threshold. This threshold is where one tax bracket ends and another begins. When income shifts from one tax bracket to a higher tax bracket, it is only the income in excess of lower tax bracket that is taxed at the higher tax rate. In other words, the higher tax rate only applies to each additional dollar of income earned and not to all income earned. People often mistakenly believe that moving into a higher tax bracket means that all income earned will be taxed at the new higher rate – that’s simply not the case and thank goodness for that. Back in the mid-1980s the federal government sought to simplify the personal tax system, in part, by reducing the number of income tax brackets. And for a time this attempt at tax simplification actually worked with Canadian taxpayers facing a mere three tax brackets – low, middle and high. Experience tells us that simplification and government mix like water and oil and, in B.C., our three tax brackets have now ballooned to nine tax brackets. To be truthful here, some of the additional tax brackets are quite small, so from a practical standpoint we’re really looking at four tax brackets – low, middle, high and highest. Rather than delve into the nitty-gritty details, let’s assume for purposes of this article that we’re still faced with three tax brackets just like in the good old days. Assume that the low tax bracket applies to taxable income up to $31,000, the middle tax bracket encompasses taxable income greater than this amount but less than $62,000 and the high tax bracket covers taxable income greater than $62,000. With this background in mind, let’s look at a situation where it may make sense to fight the urge to minimize taxable income. Assume Mrs. Dee Duct has income from employment of $36,000 and, being flush with cash this year, she managed to sock away $10,000 in her RRSP. Before claiming her RRSP deduction, Dee calculates that she will owe $6,204 of income tax. Adding her $10,000 RRSP deduction to the mix, Dee finds her tax liability has dropped to $3,635 saving her a princely sum of $2,569 – yahoo, sign that tax return and get it in the mail! But hold on a minute, aren’t RRSP deductions discretionary? You bet they are and this means Dee can do better than deduct her entire contribution this year. Using what she knows about tax brackets, Dee can realize an additional 7 per cent return on her contribution by resisting the urge to deduct. Because her employment income is pretty steady each year, Dee decides to reduce her RRSP deduction in 2002 to $5,000 and carry the remaining $5,000 amount forward for deduction against her 2003 income. By claiming only $5,000 of her RRSP in 2002, Dee has effectively applied her deduction only against income taxed at the middle rate - the same will be true when she claims the remaining $5,000 amount in 2003. Following this approach, Dee finds that her $5,000 RRSP deduction claim in 2002 has saved her $1,466 of income tax – she notes that this is less than the $2,569 she figured on saving by deducting the full $10,000 but Dee also knows that she’ll save the same amount next year when she deducts the remaining $5,000 RRSP contribution she chose to forego this year. Considering both years together, the total tax saving Dee will enjoy ends up being $2,932 or $363 more than the deduct-it-all-in-one-year approach. Sure she will have to wait one whole year for one-half of her tax saving but the extra $363 she’ll receive is the equivalent of a 7.3 per cent after-tax, effectively risk-free, return on the $5,000 RRSP contribution she deferred deducting. Try and beat that in today’s low-interest rate environment! Okay, fair enough but what if you don’t have an RRSP contribution to fool around with. Well, there are other discretionary deductions that can be used in the same manner. For example, if you own your own car, and you use it for employment purposes, you’re entitled to claim a deduction for capital cost allowance (CCA) or tax depreciation on your vehicle. CCA is a discretionary deduction. If your taxable income is hovering around a tax bracket threshold you can choose to reduce or eliminate the CCA claim this year in favour of claiming the amount next year when your taxable income will be subject to a higher tax rate. The same opportunity exists for the self-employed who are often in a position to claim CCA on computer equipment, office furniture and so on. To minimize their overall tax liability, taxpayers need to be keenly aware of tax brackets and their income in the current tax year and future tax years.
Free Tax Advice Article Submitted to Income Tax Canada.net exclusively by Jim Maroney Official details about this and other topics on income taxes can be found in English & Francais at www.ccra-adrc.gc.ca Income tax information offered by www.IncomeTaxCanada.net is done so without endorsement by Canada Revenue Agency (CRA) - l'Agence du Revenu du Canada (ARC) (formerly Canada Customs and Revenue Agency - l'Agence des Douanes et du Revenu du Canada CCRA-ADRC and formerly Revenue Canada – Revenu du Canada) or any Canadian government agency. The free advice is of a general nature for Canadian taxpayers seeking legal ways to reduce their personal and small business income taxes payable to the federal and provincial (or territorial) governments in Alberta, British Columbia, Manitoba, New Brunswick Newfoundland-Labrador, Northwest Territories, Nova Scotia, Nunavut, Ontario, Prince Edward Island, Quebec, Saskatchewan or Yukon. Specific taxation situations vary from taxpayer to taxpayer, province to province, territory to territory. The free tax advice here is only a general guide. Canadians should always seek individual guidance on accounting rules and tax laws from knowledgeable accountants and lawyers. To prepare your income tax return online and NetFile your Canadian income taxes electronically in English or Francais, please visit www.ufile.ca or www.impotexpert.ca websites. Additional information on financial products and services for Canadians can be found at www.CanadianCreditCenter.com. |
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Jim Maroney