According to a study conducted by Fraser Institute, an independent Canadian public policy research and educational organization, taxes are the highest expenses for many households.
The average Canadian family spent 44.2 percent of its income on taxes alone, compared to just 36.3 percent for basic necessities like housing, clothing and food.
Given this , it is surprising how little time and effort people spend on planning and organizing their finances to reduce taxes.
Tax Evasion vs Tax Avoidance
To be clear, we’re not suggesting that you hide your income from the taxman. Not only is this unsustainable and unwise, it will only get you in serious trouble when caught.
The penalty for tax evasion is costly: from paying the full amount of taxes owed plus interest, to fines and even jail time.
According to CRA, Tax evasion occurs when an individual or business intentionally ignores Canada’s tax laws. This includes falsifying records and claims, purposely not reporting income, or inflating expenses.
On the other hand, Tax avoidance is the use of legal methods to modify an individual’s financial situation to lower the amount of income tax owed. This is generally accomplished by claiming the permissible deductions and credits. (Investopedia)
Simply put, tax avoidance seeks to minimize taxes while tax avoidance avoids paying taxes using illegal means.
In this post, we’ll discuss some of the legal ways to reduce your tax liability as a Canadian tax payer.
1. Claim all tax deductions and credits
Many of the tips below will come in form of tax deductions and tax credits. Knowing and claiming all eligible deductions is one of the easiest means for saving tax available to every taxpayer.
Tax deductions reduce the income you pay taxes on; while tax credits reduce the tax payable.
CRA puts it this way:
Income tax is based on your taxable income, not your total income. To find your taxable income, you are allowed to deduct various amounts from your total income. Tax credits then apply to reduce the tax that is payable on the taxable income
A simple illustration: Assume a taxpayer with a total income of $100,000 and tax rate of 20 percent that is eligible for a tax deduction of $10,000. The tax payable will be $18,000; that is 20% of $90,000 ($100,000 – $10,000). If she’s eligible for an additional tax credit of $2,000, this will further reduce the tax payable to just $16,000.
At the minimum, every Canadian is eligible for the Basic personal credit of $12,609 for the 2019 tax year. This means, you pay no tax on any income below this since the tax credit wipes out the tax payable.
You can find a list of all tax credits and deductions here.
2. Take advantage of tax-deferred investments
Maxing out your contributions to tax-advantaged savings account can reduce your taxes in two ways.
- Your investments will grow tax-free: Using any of the registered savings plans (RRSP, TFSA, RESP etc), shield your investment income from tax until they are withdrawn. There is no tax payable for TFSA withdrawals.
- You may get a refund: Registered retirement saving plan (RRSP) not only help you save for retirement, it also has some tax benefits. Any amount contributed to an RRSP will reduce your taxable income, with a tax refund received from CRA when taxes are filed.
How much can I contribute to RRSP in 2020?
The RRSP contribution limit for 2020 is 18% of the earned income reported on your tax return for 2019, up to a maximum of $27,230. The upper limit is $27,830 for 2021.
When is the deadline to contribute to an RRSP?
To take advantage of the RRSP deduction, you had till March 1, 2020 to contribute for the 2019 tax year. The deadline is typically the 60th day of the year or the next working day, if it falls on a weekend.
For the 2020 tax year, the deadline to contribute to RRSP is March 1st, 2021.
3. Consider the tax implications of the returns on your investments
At some point, you may max out your contribution rooms in the registered accounts and need to invest or save in a non-registered account.
Generally, income from investments will take the form of capital gains, dividends or interest. Each one has different tax treatment as explained below.
Capital gains are triggered when you sell an investment at a price higher than what was paid for it. Fortunately, only 50% of the gain is taxed in the year the investment is sold.
Dividends are an after tax distribution of profits by corporations to their shareholders or investors. They are more tax efficient than interest because they qualify for a special dividend tax credit. So investing in a Canadian corporation that pays you dividend is tax-wise.
Lastly, Interests are charged at your marginal rate. Any interest earned within the year is simply added to your total income from other sources, with no tax advantage.
To reduce the taxes paid on your investment income, you should consider holding interest earning assets in your registered accounts.
4. Buy less stuff
Though often ignored, the GST/HST can quickly add up over time.
For example, going on a $1,000 spending spree in Ontario with an HST of 13 percent, will not only reduce what you can keep as savings, it will also cost you $130 in sales tax.
Over a 12 months period, the sales tax paid can add up to a substantial amount.
5. Donate to Charity
A donation is a gift for which nothing is received in return (apart from the satisfaction maybe). It can be cash or any asset of value, including your investments.
You can claim the tax credit by simply reporting the donation in your tax returns. To take full advantage of the credit, you may want to accumulate your donations over multiple years and claim them in a single year or combine them with your spouse’s.
This is because the tax credit is higher for donations above $200. At the federal level, the tax credit is 15% on the first $200 and 29% on any additional amount.
The rate varies for the provinces and territories.
Donations can be carried over for up to five years. Make sure you keep the donation receipts. You can find a list of approved charities here.
A bonus point and perhaps the most important one for some people:
6. Use a tax professional
The CRA administers a number of taxation acts that runs over 3,000 pages when consolidated. Though many of them will not be applicable or relevant to the average tax-payer, it is still necessary to acknowledge just how complicated the income tax laws can be.
In recent years, the move to DIY tax preparation has been on the rise. Canadians now have many options to file their own taxes without the need to consult a CPA or tax professional. From inexpensive tools to the free alternatives, the options are numerous.
However, there is still a case to be made for using a tax professional. They are versed in the tax laws, keep informed of changes, can help you navigate the seemingly complex areas and ensure you claim all the tax deductions and credits you are entitled to.
We wrote about when to do your own taxes vs using a professional here, and it’s worth a read.
In conclusion, with the ever-changing tax laws and regulations, tax planning should be a continuous process. Some of the strategies above may not be relevant to you now, but they could be in a few years time. The key is to always plan in advance.
Contrary to what most people believe, it is perfectly legal to find ways to reduce your tax liability. Infact, the CRA has a page on Reducing your taxes.
You worked hard for your money and any amount not paid out as taxes is more money to save or invest to reach your financial goals.