The Basics of Tax Planning

For most of us, doing our taxes is on par with getting a root canal. Unfortunately, there is no way around many of the headaches that the tax system brings on.

But it can pay to take some time to familiarize your self with Canada's tax system. With a little effort, you may be able to ring up some substantial gains. Knowing how the tax system works means you can take advantage of the many legitimate opportunities for minimizing the tax you pay.

A good place to start is to dig out your last tax return to see how much tax you actually paid last year. On the federal T1 General form, start with the sum on line 435, which is total tax payable. Subtract any credits deducted from your total tax payable, but don't take away the credit for income tax you've already deducted - that's on line 437, or the tax you paid by installments - that's on line 476. Now get out your pen and write down the resulting number down. That's how much you paid in tax last year. Ouch!

To find out more...

• Personal Income Tax Parameters
• Your Marginal Tax Rate
• Tax Deductions and Tax Credits
• Attribution Rules
• Taxes and Your Investments
• Minimize Taxes Through RRSPs
• Tax Loopholes
• Year End Tax Planning
• Tax Changes for 2010
• CRA Top 10 List

Personal Income Tax Parameters

Under the current tax on income method, provincial tax for all provinces (except Quebec) and territories is calculated the same way as federal tax. The rate below applies to Ontario only.

Your Marginal Tax Rate

In most cases, your total tax payable means paying the Canada Revenue Agency was one of your biggest expenses last year. The good news is, if you spend some time making sure you're taking advantage of all your available deductions and credits, and implement some tax-planning strategies (such as income splitting) you may be able to slash significant dollars off your tax bill. At the same time, understanding the tax system may also save you money by helping you avoid penalties and interest charges.

One of the key concepts in getting your head around our tax system - as well as finding ways to cut your tax bill - is your marginal tax rate. There are really two tax rates that you'll need to be concerned about. This may come as a surprise to you. After all, when you see your tax deduction on your paystub, there is only one figure. If your income goes up, so do your taxes. When you make less money, you pay less tax. This is what is known as a progressive tax system.

Not every dollar you make is taxed at the same rate. There are four federal tax brackets, and different portions of your income are taxed at different levels.

When you pay tax, whether it's deducted from your pay, you submit it for a business, or you send the Canada Revenue Agency a cheque at tax time, the numbers are added up and presented to you as if you were paying the same rate on every dollar you make. This is what's known as your effective tax.

Your marginal tax rate refers to the rate at which the last dollars you earn in any year are taxed. For example, suppose you make $62,000. Your marginal tax rate would be 43 per cent. In other words, if you made an extra $1,000, you'd have to give the government $430. But suppose your income is only $4,000 less, or $58,000 a year. Then your marginal tax rate would only be 33 per cent. So if you made that extra $1,000, you'd only have to pay $330 in tax, leaving you with an extra $100.

* Based on top personal income threshold of $ $126,264
* Combined Federal & Provincial Tax Rates for 2009 (includes surtaxes where applicable).

Tax Deductions

The more money you make, the higher your tax bracket, and the more tax you pay. And that means the higher your tax bracket, the more a deduction is worth to you.

For example, if you were in the lowest tax bracket of 21% and you had a $2,000 deduction for moving expenses, you could deduct that from your income before your taxes were calculated. The savings to you would be the tax you would otherwise have had to pay on that $2,000 which is $420.
Now let's consider that you're in a 50% tax bracket. That same $2,000 deduction would be worth $1,000 of tax savings. In short, a deduction saves you exactly the amount of the deduction multiplied by your marginal tax rate.

Tax Credits

Unlike a deduction, a credit does not reduce your taxable income. Instead, it comes into effect once the amount of tax you owe has been determined. For example, let's say you owed $10,000 in federal tax. If you had a $1,000 tax credit, you would simply deduct this from your federal tax payable, reducing it to $9,000. (Deductions are expenditures that can be reduced from your overall income for tax saving purposes. Examples include RRSP contributions, alimony, child care expenses, union and professional dues.)

With tax credits, your marginal tax rate doesn't come into play at all. The result is that a tax credit is worth the same in real dollars to everybody, regardless of their income level and tax bracket. As part of an effort to make the tax system more fair, the government has been converting many deductions into tax credits.

When a $1,000 Tax Credit is Worth $1,500 - or More!

Most tax credits are subtracted from the amount of basic federal tax you are required to pay. Since your provincial taxes and federal surtaxes are calculated on your basic federal tax, this means each dollar of credit can actually save you upwards of $1.50 in taxes!

(Your provincial taxes are calculated as a percentage of your basic federal tax, so the less tax you owe Ottawa, the less you'll have to pay your province. Provincial tax rates range from around 45 to 70 per cent of your federal tax bill. In addition, tax credits are subtracted from your basic federal tax before assessing your federal surtax, making your credits worth even more.)

Refundable and Non-Refundable Tax Credits

Refundable credits are always worth in real dollars what they're worth on paper. They're treated as if the money was actually paid to the government, just as when income tax is deducted from your paycheque. If you didn't have to pay that money into the system, you get it back.

Non-refundable tax credits, however, may be worth a lot less than the number you fill in on your tax return, right down to zero. This can happen if a minimal income - or lots of deductions - means you'll have little, if any, federal tax to pay. The most non-refundable tax credits can do for you is to eliminate federal tax (and the associated provincial taxes and federal surtax). What they can't do is get you a refund worth more than the tax you paid. Say you had a basic federal tax payable of $2,000, and you had $3,500 of non-refundable credits. Your tax payable will be zero, but you would not get a cheque from the government for $1,500.

Sometimes, however, if you can't make use of a non-refundable tax credit, it can be transferred to other people in your family.

Attribution Rules: Finding ways to lower taxes

Income splitting is a strategy for decreasing the tax burden of a family. Here's how it works: Money or property is loaned or transferred to a lower-income family member so that gains are taxed at a lower rate. It can be a great way to minimize taxes, but attribution rules can block many of these opportunities. 

The first thing you need to know about attribution rules is that they are very complicated. The rules were designed to prevent attempts to shift income to another person by attributing it back to the person who transferred the money or property.

In other words, if a wife transfers investments to her lower-income husband, income realized on the investments could be assigned back to the wife. So, while the husband receives the income, the wife still pays tax on it at her marginal rate, and the family is no further ahead.

There are a lot of rules in the Income Tax Act pertaining to attribution, and many of them are intended to foil circumvention of the general rules. One of the most misunderstood attribution rules is significant because of its scope. The rule states that trust income is attributed to the person who transfers property to a trust when that person reserves the right to take back the property or retain some control over it. This rule applies to certain specific circumstances, and professional guidance is advised.

However, in spite of the numerous attribution rules, some income-splitting opportunities do exist. For example, a higher income family member can pay all of the family's living expenses, leaving the lower income person with more to invest. Also, the child tax benefit may be invested in a child's name without any attribution of income back to the parents.

As in all matters related to tax planning, it's important to understand the rules and how they affect your specific situation.

Taxes and Your Investments

The only real number that matters to you when it comes to investing is what you make after the Canada Revenue Agency takes its share - or, your after-tax rate of return. A fixed-income investment paying 7% sounds good, but consider your after-tax return. If you were in the top tax bracket of around 50 per cent, you would only make 3.5%, which is quite a difference (assuming the investment is outside of your RRSP).

What is more, the amount of tax that you pay varies with the type of investment. This can have a great impact on your after-tax return, as well as how you arrange your portfolio. (Note that you don't have to pay any tax on gains earned by money in a tax-sheltered account such as an RRSP or a RRIF until you make a withdrawal.)

The most heavily taxed type of investments are those that earn you interest income, such as GICs or CSBs. Stocks, real estate, and other investments that entail more risk but have the potential for higher returns in the form of capital gains are taxed less. Dividends from Canadian corporations have the lowest effective tax rate.

After-tax return of $1,000.00 investment

• Tax Efficient Investing

Minimize Taxes Through RRSPs

Recognize a tax break when you see one! Registered Retirement Savings Plans (RRSPs) are the most effective way for you to save money for your retirement and the contributions you make into your RRSP are tax deductible. Within your RRSP, you can tailor your investments to fit your goals and style. If you're married to a lower-earning spouse, you can contribute to a spousal RRSP, reducing your own retirement income and the tax bite it incurs.

A Great Tax Savings Idea!

Investing into a Labour Sponsored Fund (LSF) can save you $1500 in taxes. LSFs are mutual funds which invest in Canadian companies that are in a growth phase and are in need of expansion financing. Here's the benefit: If you invest $5,000 into a LSF, the federal and the provincial government will each give you a 15% tax credit on the $5,000. Therefore, your $5,000 investment will actually save you $1,500 in taxes. In addition, if you buy a LSF inside your RRSP, you will also get the RRSP deduction. Depending on your tax bracket, you could get back close to $4,000 as a tax refund.

You need to know however, that these funds are considered aggressive as they are investing in smaller Canadian companies and you must hold onto the fund for eight years in order to maintain the tax credits.

Tax Loopholes

Here's a little-known tax fact: most loopholes are intentional, created by the Ministry of Finance to stimulate certain sectors of the economy.

For example, if your employer buys a $30,000 car on Dec. 31, you can write off half a year's depreciation, or $4,500, even though this new asset was held for only one day. This is no oversight. More likely, it's an incentive for businesses to purchase cars.

In contrast, true loopholes are unintentional benefits you find only by reading between the lines of the Income Tax Act. Here's a good one if your spouse has losses and you have gains on your investments:

Shifting Capital Loss From One Spouse to Another

Let's consider an example: Susan is sitting on a capital loss this year, while her husband, Tim, realized a capital gain. According to the letter of the law, Tim cannot use Susan's loss to offset his gain. He will have to pay tax on his gain, while Susan's loss remains unused until she can apply it to a future capital gain of her own.

By reading the Income Tax Act closely, there is a solution. To share a capital loss with her husband, all Susan has to do is sell her losing shares to Tim, allowing him to claim the loss as his own. Let me explain.

We'll assume that Susan's shares originally cost $10,000, but are now worth $1,000 – a potential loss of $9,000. She sells the shares to Tim at the fair market value of $1,000, then elects on her income tax return not to have the transaction occur at cost.

This allows her husband, as the purchaser of the shares, to add the $9,000 capital loss to his adjusted cost base for tax calculation purposes. Now Tim owns shares with a fair market value of $1,000 and an adjusted cost base of $10,000.

The final step is for Tim to simply sell the shares. The $9,000 loss goes on his books, and not Susan's, because he bought the shares from her at fair market value.

While this may sound complicated, it really isn't in practice. Keep in mind however, that this loophole applies only to spousal transfers of capital property; in other words, it won't work if you sell losing shares to another family member or a friend.

Year-End Tax Planning

Year-end means the onset of winter, the holiday season and, like it or not, a certain amount of financial planning. This year, especially, tax-loss planning could help ease any financial blow you may have felt and put more after-tax dollars in your pocket. Here are some strategies you should be considering now – before the end of the year – in order to reap the greatest benefit.

1. Tax-Loss Selling

In times like these, when markets are volatile and investors sustain more than the usual capital losses, tax-loss selling can be a silver-lining strategy.

There are several ways to approach this strategy:

• transferring unrealized capital losses from a spouse or common-law partner
• You can also donate securities to a registered charity by year-end to receive a tax credit
• If you have investments with unrealized capital losses, you can sell them before year-end to realize the loss; then use the loss to offset realized capital gains in the current year (which will minimize taxes).
• Or, you can offset any capital gains you may have incurred in the past three years, or carry the loss forward indefinitely to offset future capital gains.

IMPORTANT NOTE!

One of the most commonly suggested loss realization strategies for clients who still want to hold on to an underlying fund is to transfer the fund with the accrued loss to an RRSP. This idea, however, comes with an important caveat - if a fund with an accrued loss is transferred to an RRSP, the loss is denied.

Instead, the fund should first be switched into a money market fund outside the RRSP and the money market fund contributed in-kind to the RRSP. The RRSP can then redeem the money market fund and repurchase the original fund.

In the past, there was no need to worry about the 30-day superficial loss rule because the individual isn't buying back the same fund - their RRSP is. The 2004 federal budget, however, amended the definition of affiliated, such that a person is now considered to be affiliated with a trust if the person is a majority interest beneficiary of the trust, which would be the case with RRSPs. As a result, the investor should either wait the 30 days before switching back from the money market fund to the original fund or consider transferring to another version of the fund inside the RRSP, such as a corporate class or RSP clone version of the fund, if available.

To take advantage of tax-loss selling and guarantee that a trade is settled in 2010, the trade date must be December 24, 2010, or earlier and settlement must take place by December 31, 2010. Talk to your advisor about these strategies and whether selling or transferring equities is right for you.

2. Estate Planning

Is your will up to date? End-of-year financial house-keeping is a good time to review your will and make sure it represents your current situation and your intentions regarding your estate.

3. Registered Plans

If you have any unused contribution room in your RRSP, consider topping it up. (The deadline for 2010 RRSP contributions is March 1, 2011.) If you turned 71 in 2010, you have only until December 31, 2010 to make a contribution to your RRSP for 2010 (but you can include 2011 contributions if you were paid a salary or wage in 2010).

4. Personal Payments

The final tax installment payment for 2010 is December 15th. Parents of children under 16 can claim a non-refundable tax credit of up to $500 for each child registered in an eligible physical activity program. For more personal payment deadlines see list below, Payments due by December 31, 2010.

5. Transit Pass Tax Credit

Provided certain conditions are met, public transit users can claim a non-refundable tax credit.

6. Mutual Fund Purchases

To avoid having to report year-end distributions, consider postponing the purchase of non-registered mutual funds until the new year.

7. Non-deductible Interest on Your Loans

Consider paying off your debt by selling some of your non-registered investments, and then borrowing to replace the investment.

8. Allocating Pension Income to your Spouse

You may be able to increase your after-tax income from your retirement plans by allocating up to one-half of eligible income that qualifies for the existing pension income tax credit to your resident spouse or common-law partner.

9. Stock Option Deferral

Stocks acquired through stock option plans can have the benefit deferred on amounts up to $100,000 in total fair market value (at the time the options were granted).

10. Tax Shelters

Seek professional advice and consult with your advisor before investing your money in a tax shelter. The quality of the product is more important than the immediate tax savings.

Tax Changes for 2010

RRSP Limit Rises to $22,000 for 2010

In the 2008 federal budget, the government further increased the retirement savings limits. For 2010, the RRSP limit increased to $22,000.

The RRSP limits and other increases are summarized in the chart below:

* Indexed to the growth in the average industrial wage.

Payments due by December 31, 2010

• Alimony payments
• Charitable donations
• Child care expenses
• Interest expenses on money borrowed to earn investment income
• Medical expenses
• Union and professional membership dues
• Investment counsel fees, interest and other investment expenses
• Political contributions
• Deductible legal fees
• Interest on student loans
• Payments eligible for the fitness tax credit
• Loan interest
• Safety deposit box fees
• Tax shelter payments
• Professional fees
• Interest on family loans (generally at the prescribed rate) must be paid by January 30, 2011 to avoid income attribution. Consider new arrangements while the prescribed rate is low – currently 3%
• Review family trusts for any action that's required by December 31, 2010.

Personal Tax Credits

The 2005 federal budget proposed that by the year 2009, the basic personal amount will be increased to at least $10,000. The federal budget also proposed to increase the spousal/partner amount to at least $8,500 by 2009 and will also adjust the threshold amount accordingly.

The proposed increases, to be implemented over four years, are in addition to increases that take effect due to the full indexation of the tax system, which was restored in the 2000 federal budget as part of the government's Five-Year Tax Reduction Plan.

The chart below summarizes the minimum proposed levels of these amounts, ignoring any additional inflation increases: