“The hardest thing in the world to understand is income taxes.”
-Albert Einstein
Albert Einstein had an accountant.
Widely regarded as one of the most intelligent humans ever to live, Einstein found taxes more complicated to understand than his theory of relativity. He said as much to his long-time friend and accountant Leo Mattersdorf:
One year, while I was at his Princeton home preparing his return, Mr. Einstein, who was then still living, asked me to stay for lunch. During the course of the meal, the professor turned to me and, with his inimitable chuckle, said:
“The hardest thing in the world to understand is income taxes.”
I replied: “There is one thing more difficult, and that is your theory of relativity.”
“Oh, no,” he replied,” that is easy.”
-Leo Mattersdorf, letter to Time Magazine, 1963
Einstein was referring to the U.S. Tax Code, but he would likely find our version—the Canadian Income Tax Act or ITA—just as baffling.
The ITA is about 3,000 pages long and well over one million words. Add in Canada Revenue Agency (CRA) information circulars, interpretation bulletins, and technical interpretations, and we have tens of thousands of pages.
To say tax planning is complex would be the understatement of the century.
But at its core, tax planning can be summarized in only four strategies.Conveniently, they all start with the letter D:
Before we review them, we must quickly walk through the Canadian income tax system.
How Does the Canadian Tax System Work?
The Canadian income tax system is progressive.
That means that, as a percentage, tax rates increase as income rises. Both federal and provincial governments collect income taxes and each province has their own tax brackets and rates. Individuals and corporations file annual tax returns to report income, claim deductions, and determine taxes owed. Income from wages and investments are subject to taxation, and credits and deductions are available to reduce taxable income and lower tax liabilities.
Canadians are allowed, and even encouraged, to use all available legal means to manage their taxes and reduce or eliminate them where possible. People focus heavily on tax planning, and rightfully so – for most, taxes represent the biggest expense they will incur over their lifetime.
But tax planning is often misunderstood. People tend to think they want to pay the least taxes possible, when they actually want the best after-tax outcome. These are not always the same thing, however. For example, if you wanted to pay less tax, you could simply stop earning income. You would have no income tax owing. But you would be far worse off financially for doing so.
Instead of trying to reduce our tax bills to $0, let’s see how the four Ds of tax planning can help us achieve better tax outcomes.
1.Deduct
A deduction reduces your taxable income.
If your salary is $100,000 annually, you expect to pay tax on the full $100,000 annually.
But if you can deduct $20,000—for example, if you contributed $20,000 to your Registered Retirement Savings Plan (RRSP)—then you are only required to pay tax on the difference of $80,000.
Deductions can be extremely valuable since they are used at your marginal rate. In BC, for 2024, combined federal and marginal tax rates on regular income are as follows:
Source: https://www.mackenzieinvestments.com/en/services/tax-and-estate-planning/tax-rates
So, if you earn $100,000 but can deduct $20,000, you’ll reduce taxes by:
That’s a tax reduction of $5,755.19 in this example.
In most cases, a deduction requires you to spend money on something. You can deduct certain business and childcare expenses, but you must spend money on your business or care for your children to deduct it. There are some exceptions, like RRSP contributions, where you are not spending the money but deferring the income to the future. We’ll talk about tax deferral in a minute.
Other common deductions include:
The Canada Revenue Agency (CRA) maintains a complete list of qualifying income deductions here:
https://www.canada.ca/en/revenue-agency/services/tax/individuals/topics/about-your-tax-return/tax-return/completing-a-tax-return/deductions-credits-expenses/deductions-credits-expenses.html
And there are dozens of online calculators to help you do the math on the value of your deduction.
2. Defer
Why pay for something today if you can pay for it tomorrow?
Sometimes, you can push taxes you owe into a future year. Doing so increases your cash flow today, and you can use it to earn a return on your money during the deferral period. By not paying the taxes today, you’ll have a higher starting balance to invest with, allowing for more efficient compounding investment returns over time. And due to inflation and the time value of money, $1 in the future is worth less than $1 today. Using those lower-value future dollars to pay the tax bill is better than using today’s higher-value dollars.
Ideally, you can defer taxes to years when your taxable income and marginal tax bracket are lower. Most Canadians will have lower taxable incomes in retirement than during their working years. Deferring taxes from high-income years to lower-income years can create absolute tax savings.
There are risks to tax deferral, though. Paying taxes today gives you certainty – you know your tax bracket and how much you’ll owe. By deferring taxes to a future year, you risk the possibility that marginal tax rates will be higher, or tax regimes will change in a way that requires you to pay more tax than expected. It could mean losing access to some government-sponsored programs like Old Age Security (OAS), which are income-tested. If you invest the deferred taxes into risky assets, they may perform poorly, significantly reducing the benefit of the deferral.
In the example above, we used a $20,000 RRSP contribution to get a tax deduction. But that income is also deferred to the future, as when you withdraw funds from the RRSP – and you must withdraw them at some point – the value of the withdrawal is taxable as income.
Other than RRSPs, other common deferral mechanisms include:
3. Divide
Since each individual can access their own set of marginal tax rates, it’s best to split taxable income across multiple people. This way, those lower income brackets are multiplied. You can split income with spouses or common-law partners, and sometimes children.
Someone earning $100,000 in BC would pay approximately $19,655 in federal and provincial taxes. But two spouses earning $50,000 each would only pay $6,144 each, or $12,288 total – a difference of $7,367.
Unfortunately, we cannot just hand over taxable income to a spouse. There are particular rules – the attribution rules – that prevent most types of income splitting at the source. There are a few simple tools available, though:
A spousal RRSP allows the contributor to deduct the contribution, but the spouse owns the RRSP account. When the spouse eventually withdraws the funds they pay tax at their rates, not the contributor’s.
You make RESP contributions with after-tax dollars. – unlike an RRSP, you don’t get an income deduction when you contribute. You can invest the funds in an RESP in various securities like stocks, bonds, ETFs, and mutual funds, and the growth is sheltered from tax while the funds remain in the plan. If the beneficiary withdraws funds for a qualifying post-secondary educational program, the tax on that investment growth is taxed in their hands, not yours. It’s the most straightforward tool available for splitting investment income with children.
While you cannot normally gift money to your spouse to invest without triggering the attribution rules, TFSAs are an exception. Since the returns are tax-free, there is no taxable income to attribute to the donor spouse. Therefore, funding a spouse’s TFSA is a terrific way to shelter even more of your investment income from tax.
You can split qualifying pension income between spouses. Eventually, most RRSP accounts become Registered Retirement Income Funds or RRIFs. RRIFs have a required annual withdrawal, and the income from a RRIF is considered qualifying pension income. Other plans, like defined benefit plans, can also be split. Depending on the type of pension income, the minimum age to be eligible for splitting is either 55 or 65.
While you cannot gift money to a spouse without triggering the attribution rules, you can loan it to them. Interest is payable based on CRA’s prescribed rate, which they update quarterly. Caution is needed, as interest payments to the gifting spouse must be made by January 30th of the following year; otherwise, the loan is dissolved.
Family members doing legitimate work for your business – including adult children – can be paid a reasonable salary.
There are other more complex ways to split income with family members. That complexity and tax risk must be weighed against the potential benefits to determine if the strategy is worthwhile.
4. Decrease
Once taxes are calculated, if eligible, you can reduce the taxes owing through tax credits. A tax credit differs from a tax deduction – a deduction lowers the income on which your taxes are payable. In contrast, a credit reduces the taxes you owe dollar for dollar.
Tax credits can be refundable or non-refundable. A non-refundable credit cannot reduce your taxes owing below $0. A refundable credit can. For example, if you owed $1,000 in taxes but had $2,000 in refundable tax credits available, you would get a $1,000 refund from CRA after filing your taxes.
Most credits are based on the lowest federal and provincial tax brackets.
For example, let’s say you have unclaimed tuition costs from medical school totalling $5,000. You do your taxes and find you have $500 in taxes owed. The federal tuition tax credit is 15%, and it’s a non-refundable credit.
$5,000 x 15% = $750
It reduces your taxes to $0, but you don’t get a refund. If it were a refundable credit instead, you would get a $250 refund.
Other ways to decrease taxes include:
Are there other Ds in tax planning?
Honourable mentions go to “disguise” and “donate.” While both are primarily captured by the four categories above, each merits a short mention.
Disguising might sound nefarious, but in some cases, it is perfectly legal. In specific circumstances, income or expenses may be recharacterized from one type to another. For example, business owners might be able to convert dividends into capital gains or convert some personal expenses or debts into deductible business expenses or debt.
Donating property to a charity can result in either a deduction or a credit, depending on whether the donation is made personally or through a business. While not a separate “D,” donating should be considered when reviewing the checklist of tax planning strategies.
When contemplating ways to improve your tax situation, the four Ds of tax planning act as a handy checklist to ensure you’ve done all you can to keep more money in your pocket and less in the CRA’s.
But like Einstein – always seek the advice of a qualified tax professional before engaging in any tax planning.
Sources:
https://quoteinvestigator.com/2011/03/07/einstein-income-taxes/#google_vignette
https://www.canada.ca/en/revenue-agency/services/tax/individuals/topics/about-your-tax-return/tax-return/completing-a-tax-return/deductions-credits-expenses/deductions-credits-expenses.html
https://www.wealthsimple.com/en-ca/tool/tax-calculator
