As a rule of thumb, tax credits are better than deductions. Here’s how they work.
There is often confusion in the Canadian income tax system of what is a deduction, non-refundable tax credit, and refundable tax credit. As a rule of thumb, tax credits are better than deductions. The purpose of this article is to outline how deductions work.
Deductions
Tax deductions reduce your taxable income, meaning you are taxed on a smaller portion of your earnings — the higher your income tax bracket, the greater the benefit of a deduction.
An individual in the first income tax bracket has a combined tax rate of 20.05 per cent (federal 15 per cent and B.C. 5.05 per cent), while an individual in the top income tax bracket has a combined tax rate of 53.50 per cent (federal 33 per cent and B.C. 20.5 per cent).
There are many tax brackets in between the lower and upper brackets. The benefit you receive from a deduction depends on your tax bracket.
Examples of deductions
RRSP
Misty is considering making an RRSP contribution of $10,000. Misty is in the lowest income tax bracket. Misty can expect to save 20.05 per cent or $2,005 in taxes if she makes a $10,000 contribution.
Darron makes an RRSP contribution of $10,000 each year. Darron is in the highest income tax bracket. Darron can expect to save 53.50 per cent or $5,350 in taxes if he makes a $10,000 contribution.
Conclusion:
A person in the highest income tax bracket will receive a greater deduction and more tax savings. Both will benefit from the deferral of future income within the RRSP until the funds are pulled out. If someone feels their taxable income will rise significantly in the future, then strategy should be utilized on when to contribute to an RRSP.
First Home Savings Account (FHSA)
Billy is currently going to university and working during the summer. His taxable income is below the basic exemption, and he has education amounts that are non-refundable tax credits. He decides to contribute $8,000 to a FHSA; however, he is not going to claim the deduction until next year when he feels he will have taxable income. This will be referred to as an unused contribution, which can be deducted in a future year.
Sally is currently in the top marginal tax bracket and is looking at purchasing her first home in the next couple of years. If Sally contributes the maximum of $8,000 to her FHSA, she will get a deduction of $4,280 off taxes payable. The best part is that when Sally goes to pull these funds out in the future, they are not taxed.
Deduction for elected split-pension amount
Ben and Patricia are both retired. Ben is in the bottom tax bracket and Patricia is in the top tax bracket. In reviewing their income tax returns, we noted that they have $15,000 of eligible pension income that could be split when they file their income tax return.
Patricia would effectively get a deduction of $15,000 at 53.5 per cent, which equates to saving $8,025 in taxes. Ben would include the $15,000 on his income tax return. Ben would have an income inclusion of $15,000 at 20.05 per cent and he would have to pay $3,007.50 in additional taxes.
As a household, the net savings is $5,017.50 ($8,025 – $3,007.50) by taking advantage of the deduction at a higher income tax rate and the inclusion at a lower income tax rate.
Annual union, professional or like dues
Wendy claimed annual union dues of $1,200 on her income tax return. Wendy is in the top marginal tax bracket. Wendy would save $642 ($1,200 x 53.50 per cent) in taxes for payment of her union dues.
Douglas has professional dues of $2,400 on his income tax return. Douglas is in the first marginal tax bracket. Douglas would save $481.20 ($2,400 x 20.05 per cent) in taxes for payment of his professional dues.
Even though Douglas had greater expenses, Wendy was able to save more in taxes as she was in a higher income tax bracket and received a larger deduction.
Childcare expenses
Robert and Rita sent their child to a special sports school where lodging is involved. The total costs were $14,000. Robert is in the top marginal tax bracket and Rita is in the lowest marginal tax bracket.
In talking to Robert and Rita, we explained to them that they must claim the expenses on the lowest net income parent. The $14,000 of childcare expenses will be reported on Rita’s income tax return and will result in tax savings of $2,807 ($14,000 x 20.05 per cent).
What is unique about this expense deduction is that the lowest income partner or spouse must report the expense. There are situations where the higher income person can claim the expense. These are outlined in Part C of form T778, and include: lower income person is enrolled in educational program, lower income person not able to care for children because of an impairment in physical or mental function, lower income person confined to a prison or similar institution, or breakdown in relationship.
Moving expenses
Under the tax rules, you can deduct your moving expenses if you move from one place to another to start a new job or begin a new business, provided your new residence is at least 40 kilometres closer to the new work or business location than the old residence.
The old rules stated that the 40 kilometers had to be measured as the crow flies, meaning a straight line. The courts ruled that the straight-line method of measuring the distance bears no relation to how an employee travels to work. Using the odometer method on the most direct route is reasonable and allowed.
A unique component of moving expenses is that they can only be applied against the income earned at your new place of employment.
If your net moving expenses paid in the year of the move are more than your net eligible income earned at the new work location in that same year, you can carry forward and deduct the unused part of those expenses from the employment or self-employment income you earn at the new work location and report it on your return in a future year.
If your moving expenses were paid in a year after the year of your move, you can claim the expenses against your employment or self-employment income earned at the new work location on your return for the year that you paid them.
Another unique part about moving expenses, is that CRA rules specify that moving expenses should be applied against the highest income for couples.
The moving expense deduction form T1-M should be printed out for those planning a move. As the form states, you can claim most amounts that you paid for moving yourself, your family, and your household items including:
Austin and Danielle moved from Ontario to Beautiful B.C. in March. The total moving costs incurred were $39,000.
Austin is in the lowest income tax bracket and Danielle is in the highest income tax bracket. Danielle can claim the $39,000 of moving expenses off of the income she earned in B.C. The income tax savings were $20,865 (39,000 x 53.50 per cent).
Support payments
Eric and Madison separated four years ago. They were married for 10 years and have two younger children. Eric is paying $2,000 per month in child support and $3,000 per month in spousal support.
The child support payments are not deductible to Eric, and Madison does not have to include these payments in her income.
The spousal support payments are taxable to Madison, and Eric can claim the spousal support payments as a deduction.
In total, Eric paid $36,000 in spousal support for the year. Madison is in the lowest income tax bracket and will have to pay tax of approximately $7,218 ($36,000 x 20.05 per cent). Eric is in the highest income tax bracket and can claim a deduction of $36,000 which will result in tax savings of $19,260 ($36,000 x 53.50 per cent).
Carrying charges
Nearly all our clients have carrying charges as a deduction. Essentially carrying charges are interest and other fees you paid to earn income from investments. Per the CRA website, they have broken this down as follows:
Annually we issue a tax receipt to our clients for the eligible investment counsel fees that they paid us. Clients who have borrowed money to earn investment income may also be able to claim carrying charge expenses.
Tony transitioned out of mutual funds in which he was paying $27,000 annually in embedded fees within his non-registered investment account. The fees were all embedded and were not an expense he could deduct on his taxes.
In meeting with Tony, we were able to sell the mutual funds and purchase all direct holding with no embedded fees. We were able to cut his fees in half to $13,500 and make 100 per cent of those fees tax deductible as investment counsel fees. We issued Tony a tax receipt for $13,500 that he paid during the year.
As Tony is in the top marginal tax bracket, he saved $7,222.50 in taxes ($13,500 x 53.50 per cent). The net cost for Tony to have his funds managed was $6,277.50 ($13,500 – $7,222.50). Every year, Tony was saving $20,722.50 by shifting out of mutual funds, investing in direct holdings, and having a fee-based account where he could claim the investment counsel fees as a carrying charge.
Other employment expenses
Jonathon is a commission-based salesperson. During the year he spent $54,000 on advertising expenses. He also spent $15,000 on food, beverages, and entertainment expenses.
Jonathon can claim all the advertising expenses and 50 per cent of the food, beverages, and entertainment expenses, which is $7,500. The total expenses Jonathon can claim is $61,500 ($54,000 + $7,500).
As Jonathon is in the top marginal tax bracket, he will save $32,902.50 ($61,500 x 53.50 per cent) in taxes by claiming these deductions.
Kevin Greenard CPA CA FMA CFP CIM is a Senior Wealth Advisor and Portfolio Manager, Wealth Management with The Greenard Group at Scotia Wealth Management in Victoria. His column appears every week at timescolonist.com. Call250.389.2138, email[email protected], or visitgreenardgroup.com.