Advanced Tax
Canada has a progressive taxation system, which means that we tax a higher proportion of every dollar earned when someone makes more money. Without getting too political, this makes a lot of sense: life puts a “tax” on earnings through the cost of basic necessities. As people make more, they have more income to spend on disposable items, so they also have the capacity to shoulder more of the tax burden.
The calculation behind progressive taxation is that there are tiers with different tax rates, or several “tax brackets.” The details on the amount of tax and income thresholds for each tax bracket are available from the Canada Revenue Agency's (CRA) website [73]. I find that in books or websites explaining them, they are often presented in the same way the government does for calculation purposes:
These are just the income taxes sent to the federal government, so a similar table usually follows with different rates and income thresholds for your provincial income tax. This approach is both too complicated and too simple to capture the idea of tax brackets, so instead I would like to try to explain it graphically.
In the first image (next page), imagine that you are filling a bucket with money you earn. The bucket is divided into a portion the government keeps, and a portion you keep. Where that dividing line falls shifts ever closer to the middle as your income increases – as you get closer to the top of the bucket. At the very bottom, the government takes nothing, this is the “basic personal amount” that, instead of appearing as a 0% bracket in the standard table above, comes through as a tax credit everyone receives. As your earnings cross about [74] $10,000 you start paying at the lowest tax bracket. At that point the government is taking about 20% of each new dollar you earn, but that does not affect the untaxed first $10,000 or so you made. That continues as your income moves up – in the example I have put a “fill line” for someone with $70,000 of regular employment earnings – those last few thousand dollars earned were taxed at about 31%. However, if you look at the total dark grey shaded area on the left, which would be the total amount of tax payable, it averages out to closer to 20%.
An illustration of progressive taxation, using rounded 2014 rates for Ontario and federal income tax. Note that that the real-life situation is more complicated than this, for instance this does not include the Ontario Health Premium or Ontario surtax, which would make the marginal rate on incomes over about $88,000 exceed 43%, vs the 37% shown. The tax payable line has several small steps because the provincial and federal cut-offs are not quite the same.
Your marginal tax rate is the percentage the government keeps on that last (or next) dollar of income. There is a lot of focus on marginal tax rate because it's what's important to consider for a lot of decision-making. For example, if you were trying to figure out what to do with some investments that had different tax efficiencies, or whether to contribute to an RRSP, then your marginal tax rate would be the critical factor. After all, your regular employment earnings will be there either way.
If, like many Canadians, you are employed by an employer, then they will give you a tax form called a T4 (and send a copy to the CRA) that will conveniently list all of your employment income, as well as some ancillary information [75] in numbered boxes that will streamline filing your taxes. One in particular will show how much tax has been withheld on your behalf through the year.
Going back to the example of someone making $70,000 per year, their total tax bill would be roughly $15,000. That is a lot of money to come up with every April, and many people might not think ahead to save up for the tax bill. To avoid a catastrophe, the government instead takes an amount off of each paycheque as a down-payment against your year-end tax bill. Ideally (from their point of view), they will withhold more than you will end up owing, and will make it up to you with a tax refund after filing – in addition to minimizing the number of people who don't pay their taxes, it provides you with an incentive to file your taxes on time. Filing, of course, being the process of filling out the forms each spring to calculate precisely what your income is, what credits and deductions you may have to reduce how much tax you must pay, and submitting that to the government.
Tax withheld is not such a difficult concept then, but it causes some problems because it's nearly invisible while refunds are highly visible. What ends up mattering the most to what you can spend and save in your life is how much tax you have to pay rather than how much is withheld through the year or refunded in the end. Where refunds can be particularly confusing is when it comes to RRSP contributions.
How RRSPs Work
Briefly, money contributed to an RRSP is saved before tax. That is, whatever amount you put into an RRSP gives you a “deduction” to remove that much from your income for the year. Because that money already had tax withheld on it through the year, it ends up increasing your refund after you file your taxes. The focus on the refund issue loses sight of how it is that RRSPs work: they let your investments grow tax-free over time, and shift the taxation to the future. So let’s modify the bucket-filling visual metaphor from before into the second image, and with a touch of sci-fi, allow me to explain it in a new way.
Let's start from someone making $70,000 as a base salary again, but now they make a $5,000 RRSP contribution. The RRSP contribution (top dark bar in the second image) escapes tax in the working years (left side) by sneaking out through a parallel dimension called a “tax shelter” by some (or “registered account”). There it grows fat, with no tax on ongoing growth, awaiting your signal to re-enter our reality when you are safely in your retirement years. When you do withdraw the money, it then comes in as taxable income (medium grey portion of RRSP funds on the right, future half of the figure). Like many people, you may be in a lower tax bracket in retirement (starting further down on the figure), so the RRSP provides an added benefit in that you'll end up paying less tax, and deferring the bill until later.
So the whole tax refund thing is just a consequence of that sci-fi time-shifting that the RRSP allows: you already had tax withheld on that income before it was lost to the RRSP time vortex. With your income reduced (in the present-day timestream) by the RRSP contribution, the government gives that tax withheld back to you as a tax refund. But it's best to consider a portion of that RRSP contribution as the government's portion that they will take back – when it comes out of the RRSP tax-shelter parallel dimension, they will take their cut then. You will not be able to spend every dollar sitting within your RRSP, some will be lost to tax. Notice that in the graphic: the RRSP contribution included the part on the left side of the bucket, the government’s portion.
For simplicity the figure doesn’t show the RRSP contribution growing between the working and retirement years, but that’s just what it will do if you invest it for the long term – and it will grow tax-free while it’s in that “parallel dimension.” Note that while withdrawals are taxed, the growth isn’t, as the government’s portion grows at the same rate to pay the future taxes (imagine that bar at double the height across the full width of the future bucket).
If you’re in the same tax bracket at retirement, the RRSP is still providing a major benefit in letting your investments grow tax-free (exactly equal to the benefit of the TFSA in that case) – indeed, this is the main benefit of the RRSP, and withdrawing at a lower rate than you contributed is just a bonus (or a penalty if your tax bracket increases).
A simple view of how RRSPs work. No tax is taken off of the amount contributed (working years, left). Contributions can grow tax-free over time, and then withdrawn at some point in the future (retirement years, right) – ideally when you will be in a lower tax bracket. At this point it is counted as income and tax is taken off (medium grey shaded region of RRSP withdrawal).
If you expect to be in a higher tax bracket in the future than you are now (for instance, if you're early into what you hope will become a high-paying career) then you may wish to hang on to your RRSP room until you're in a higher tax bracket, particularly if you have TFSA room to use instead. However, the benefit of tax-free compounding can outweigh a small difference in tax rates separated by many years, so you’ll have to do some math to see if a non-registered (taxable) account would be better if you expect your tax rate to increase in the near future. And don’t forget that when it’s a close call, an RRSP also frees you of the burden to track and report the gains on your investments.
When withdrawing money from your RRSP, your bank will issue you a T4RSP – analogous to the T4 received from your employer – reporting the amount of the withdrawal, which will add to your income. Similar to employment earnings, tax will be withheld from your withdrawal, with the rate depending on how much you withdraw. If you convert your RRSP to an RRIF [76] then the withdrawals count as pension income rather than ordinary income, which gets you a small tax credit.
Comparatively, the TFSA is a simpler concept: you take your money (your after tax take-home pay) and put it in a special account where further investment returns and interest are not taxed. The in/out contribution rules can be a source of confusion but it is overall much simpler.
Taxable Investment Income: If you can't shelter all of your investments from taxes in your TFSA or RRSP, then you'll have to include certain components of your non-registered investment returns in your taxable income. For savings accounts and GICs you will receive a T5 slip for any interest income over $50/yr, which makes filing your taxes just as easy as copying the amounts in the boxes to your tax software. If you don't cross the $50 threshold you still have to report and pay tax on the interest income, but it's up to you to add up your statements to report it. Yes, even the $2 in interest you got from your chequing account over the year.
For mutual funds and ETFs, you will have several kinds of income. Dividends, interest, or other distributions will be reported on T3 or T5 slips, which your brokerage will send to you. Capital gains are your responsibility to track, and that tracking was covered in detail earlier (Record-Keeping).
Capital gains can be confusing in some situations. Only half of your net capital gains are added to your income for the year (making them tax efficient), and you can carry any net capital losses forward to reduce future capital gains or revise past tax returns up to three years in the past to reduce past capital gains.
Perhaps the most confusing component is the superficial loss rule: if you sell an investment at a loss, you can't use the loss to reduce your capital gains if you bought the same investment within 30 days (either before or after), instead you just continue to follow the adjusted cost until you finally sell the security without re-buying it, or sell it with a capital gain (there is no parallel “superficial gain” rule). Basically, this is to prevent people from temporarily selling something that is down and claiming the loss on their taxes if they were to continue to hold it for the long term (people are always looking for ways to reduce their current taxes).
If you don't sell then you do not have capital gains (or losses) to report on your taxes. That is, capital gains (and losses) can be deferred until you do sell. The notable exception is a “deemed disposition” where you may still own something, but had a transaction that counts as a sale. The most common case of this is when you do an in-kind contribution of a fund or ETF to your TFSA or RRSP: once it goes into the tax shelter, you will have to pay tax on any gains made up to that point (though you cannot claim any losses).
Joint accounts are the final point of common confusion. The portion of the gains in a joint account is supposed to be allocated according to who owns that portion of the underlying asset, which the CRA will determine based on who put the money in. You may consider the money “ours, equally” but the CRA may say it's “100% hers” based on where the funds in the joint account came from. A consequence is that you can't just arbitrarily change who the owner is to put your dividends and capital gains into the name of your lower-income spouse each year.
If you share assets with a partner (whether through joint accounts or individual ones), and you wish to have the non-registered investments taxed in the hands of the lower-income partner, then that partner has to contribute the funds. You can't just have the higher-income partner deposit some money in the lower-income partner's account – the CRA could decide that the “beneficial owner” is the higher-income partner in that case and allocate the tax burden (and marginal tax rate) accordingly. One strategy is to have the higher-income partner pay more of the household expenses so that the lower-income partner can invest proportionately more of their income. Another strategy is to set up a loan between partners (and yes, you have to pay each other interest), but is getting beyond the scope here.
Footnotes:
73: http://www.cra-arc.gc.ca/tx/ndvdls/fq/txrts-eng.html
74: The basic personal amount is different federally and provincially, $11,635 for the federal amount and $10,171 for the Ontario amount in 2017. Hence the "about".
75: For example, how much you paid through a payroll deduction for transit passes, union dues, pension contributions, etc.
76: RRIF stands for Registered Retirement Income Fund, basically an RRSP that forces you to withdraw a minimum amount each year. You must convert your RRSP into an RRIF by age 71, and can opt to do it before that. The minimums are available at: http://www.cra-arc.gc.ca/E/pub/tp/ic78-18r6/ic78-18r6-e.html