Tax Season: Understanding Tax Deductions and Tax Credits
As sure as the snow will inevitably melt away in the spring, so will a portion of our income as it is paid to the Canada Revenue Agency. Many employed people will have overpaid their income taxes in the course of the year and are hoping for a tax refund. Others may have significant sources of income that are not taxed at the source and will have tax owing in the spring. Regardless of your particular situation, it is wise to review the opportunities that the Income Tax Act provides for you to reduce your taxes, either through deductions or credits.
Tax Deduction Opportunities
Tax deductions are methods of reducing your taxable income, thereby indirectly reducing your taxes.
Strategies that Reduce Taxable Income in the Current Year
Sources for deductions in this category come from two primary sources:
Registered Pension Plan (RPP)
Not all employers offer a pension plan and there are various ways in which they can be structured. One example of a defined contribution pension plan might involve an employer contributing a mandatory minimum amount to a pension plan with an additional optional amount that matches the employees’ contributions to a certain level, incentivizing employees to make their own contributions.
For example, an employer might pay 3% of the employees’ earnings into the plan. Voluntarily, employees may choose to contribute up to an additional 3.89% of earnings which the employer will match at 80% of the employees’ contributions. For an employee earning $60,000 per year, who takes full advantage of the employer match, that results in $6,000 toward retirement savings, none of which is taxable in the year it is contributed.
According to a study made by Sun Life Financial, employers pay out less than 50% of the available matching funds to their employees due to a lack of employee participation. In the table below, for a contribution of a little more than $2,300, an employee has a total contribution to their pension plan of $6,000, more than doubling the employer’s contribution to the plan versus the minimal $1,800 contribution available at the mandatory level.
Registered Retirement Savings Plan (RRSP)
The contributions in the scenario above result in a Pension Adjustment (PA) of $6,000. As you may know, contributions to an RRSP are based on 18% of earned income. Assuming employment income is the only qualifying earned income in this scenario and the employee has maximized previous contributions, this will result in new contribution room, formally the “RRSP Deduction Limit,” of $4,800. Contributing this amount to amount to an RRSP will further reduce taxable income.
Strategies that Reduce the Taxation of Assets in the future
Tax-Free Savings Account (TFSA)
Pension plans and RRSPs give you immediate relief from the taxation of income. They also defer tax on any income you earn within the respective plans. However, you pay income tax at ordinary income rates on the withdrawals from these plans, typically in your retirement years. The expectation is that you are in a higher income tax bracket now than you will be in retirement.
Another account type, however, allows you to eliminate taxation entirely, albeit, at the expense of not getting a tax deduction now. Here I am talking about the Tax-Free Savings Account (TFSA). Among the benefits of the TFSA is that because no taxes are applicable on earnings or withdrawals, attribution rules do not apply. Attribution rules stipulate that money given to one spouse by the other has any of the subsequent taxable income attributed back to the gifting spouse. In that sense, the TFSA is also a kind of income-splitting tool.
If you have been eligible since TFSAs became available in 2009, as of 2022 your TFSA contribution room has grown to $81,500 unless you have contributed and subsequently withdrawn from TFSAs in the past. In that case, the exact figure may be different.
Strategies that Split Income Between Spouses
In retirement, one of the best ways in which to reduce your income tax while maintaining the same overall income is to seek to equalize your income. Although the government has introduced several income-splitting opportunities in retirement, particularly for those over 65, if it seems likely that one or the other of a spouse will retire with a lower income, it may be to your advantage to open a spousal RRSP for the one likely to have the lower retirement income. The contributing spouse will still receive the tax deduction, but at retirement, the withdrawals will be taxed in the hands of the recipient spouse. Given that income can vary over the years of a couple’s respective careers, it may make sense for both spouses to have spousal RRSPs to make strategic contributions to achieve a closer likelihood of equal incomes in retirement. Note that when using a spousal RRSP, if the recipient spouse withdraws money, any contributions made in the year of the withdrawal or the previous two years are attributed back to the contributing spouse.
Investment Loan to Spouse
If or when a married or common-law couple gets to the point of opening a non-registered account or accounts, it may make sense for the higher-income spouse to lend money to the lower-income spouse to purchase investments. The current prescribed rate, set by the government, is 1%.
The investment loan allows the higher-earning lender to provide funds to the lower-earning borrower to invest without attribution. The lower-earning spouse would then claim any income earned at presumably a lower tax rate, effectively allowing the splitting of income. As for the interest on the loan, this is reportable as income to the lending spouse and tax-deductible as an investment expense to the borrowing spouse.
An investment loan to one or the other spouse may not be an appropriate strategy for you at this time, but it is something you may wish to consider in the future.
Canada Pension Plan
For younger persons, this is an opportunity for the future, but you will be able to split a portion of your Canada Pension Plan payments when you begin receiving those payments. The amount is determined by the number of years you were married divided by the 47-year contributory period (the difference between ages 18 to 65). For example, if you were married for 35 years before taking CPP, you would each be able to split 35/47 of your pension with each other. Of course, there is a greater benefit when there is a significant difference between the amount of CPP that is due to each of you. While there is some benefit to this plan, it is often relatively minor and takes somewhat cumbersome paperwork to either apply for or cancel.
Private (Employer) Pension Plans
Income from pension plans can be split between spouses. Some are only eligible to be split when the annuitant (recipient of the pension) is age 65 or older, but many plans can be split even if the annuitant is younger than age 65. Unlike splitting CPP, this strategy can be accomplished, or declined, each year at the time you file your taxes.
Registered Retirement Income Funds (RRIFs)/Life Income Funds (LIFs)
If one spouse is without a pension plan, the bulk of retirement savings will likely go into an RRSP, which will then be converted into a source of income from a Registered Retirement Income Fund (RRIF) at retirement. This money can be split with one’s spouse once the annuitant has reached age 65.
Life Income Funds (LIFs) are converted from Locked-In RRSPs or Locked-In Retirement Accounts, just as RRIFs are converted from RRSPs. These are also eligible for splitting after the annuitant reaches age 65.
Strategies that Split Income between Parents and Children
Registered Education Savings Plan (RESP)
The conventional way to think of the RESP is as a plan that allows you to save for your children’s education. This is correct. However, it can also be understood as a form of income splitting. If a portion of your investment money is set aside in a non-registered account for your children’s education, as long as it is in your hands you will be taxed on the interest or dividends received or on any capital gains that are realized. With an RESP, though, the money set aside for your children’s education grows tax-free while in the account and is then taxed in the beneficiary student’s hands when withdrawn.
Informal Trust Accounts
In the earlier years of the RESP, the incentives to contribute were not as strong as they are now. Consequently, many parents with the means to save for their children’s post-secondary education would set up informal trust accounts. To my knowledge, financial institutions continue to make these available. An account might be titled something like: Jane and John Doe In Trust For (often abbreviated as ITF) “Junior” Doe. With these types of trusts, while the child is a minor, income from interest and dividends is attributed to the parents, but capital gains are taxable in the hands of the child.
The benefits of using this approach are at least two: 1. there is no formal trust paperwork, 2. The accumulated assets can be used for any purpose, not just education.
One of the big disadvantages of an informal trust is that once the child reaches the age of majority, the parents may lose control of the assets in the account. The child can assert ownership by law. To resolve this, one can draw up a formal trust, which can specify how and when the assets are to be used by the beneficiary. However, a formal trust requires additional paperwork and expenses that may not justify such measures.
Tax Credit Opportunities
Tax credits differ from tax deductions in that the final figure is applied directly against the taxes owing. Note that these are all non-refundable tax credits, which means they cannot be used after bringing your taxes to zero, except to the extent they are transferrable to a spouse or parent.
This credit is available to seniors age 65 or older. The maximum credit available in 2021 is $7,713 and will rise to $7,898 for the 2022 tax year. This figure is multiplied by 15% to arrive at the federal tax savings. It is means-tested, however, so if you are still earning a higher income in your senior years, you may only be able to receive a reduced credit or no credit at all. Note that this credit can be shared with a spouse so that if one spouse does not require the full credit to reduce taxes payable to zero, it can be passed on to the other spouse.
Charitable Donation Credit
The Charitable Donation Tax Credit can be combined between spouses. Most tax credits apply a 15% federal rate to the dollar figure on which the credit is based. In the case of the Charitable Donation Tax Credit, however, after $200 in a given year, a higher federal rate of 29% applies to the balance, with exceptions. Each province also has its own applicable rates. Below is an example of the donation credit as applied to Ontario residents for qualifying charitable donations of $5,000. Between the Federal and Ontario tax credits, that should reduce $1,967.78 from the taxes that are owed.
Although this may never be an issue, you may become disabled for a period. For 2022, the federal DTC amount is $8,870. You then multiply that figure by 15%, the lowest federal tax rate to determine your credit, which is $1,330.50. This is the figure by which your federal taxes are reduced. If you cannot use all of the credit, the remaining portion can be transferred to a spouse. Fortunately, the credit can be split with an able-bodied spouse.
Medical Expense Credit
If some portion of your household’s medical expenses is uninsured, you may be able to claim a medical expense tax credit for any twelve-month period ending in the tax year for which you are filing a return. In the table below, I lay out a hypothetical comparative scenario between a couple who have different incomes as to who should claim the medical expense credit. You will note that it is advantageous for the lower-income spouse to apply.
You can see that it is generally advantageous for the lower-income spouse to claim this credit. The provinces offer similar credits.
Pension Income Credit
Obviously, this only applies in your pension-receiving years. If one of you receives more of a pension than the other, or one receives a pension while the other does not, and you meet the applicable age criterion, the pensions can be split. Each person receiving pension income can claim a $2,000 credit. If a split is done, then it is as though both of you are receiving pension income and both of you can therefore claim the Pension Income Credit.
This is likely familiar to anyone who has undertaken post-secondary education. Single persons in school can use the tuition credit themselves or, if they were unable to use it entirely because of insufficient income, it can be transferred to a parent. In the case of a married or common-law couple, if either partner received a tuition tax credit but was unable to use the entirety of the credit, up to $5,000 can be transferred to the other spouse. Note that any amounts carried forward to future years, that is, left unused either by the student directly or through a transfer to a parent or spouse, are not eligible to be transferred in future years.
Canada’s income tax system is becoming increasingly complex as governments tweak the deductions or credits to advance their fiscal and social agendas. Fortunately, the various software options that many of us use to complete our tax returns are built to prompt us to take advantage of these opportunities when they exist. However, do not be reluctant to use a professional when your circumstances call for it. Paying a couple of hundred dollars more to save thousands seems a reasonable calculation.
This is the 136th blog post for Russ Writes, first published on 2022-02-21.
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Disclaimer: This blog post is intended for general information and discussion purposes only. It should not be relied upon for investment, insurance, tax, or legal decisions.