Noh Review Taxation: RRSP and Tax Planning

In this post, I will discuss:
1) What an RRSP is
2) The Benefits of an RRSP
3) Contribution Amount Allowed
4) Eligibility
5) Income Splitting
6) RRSP Withdrawal
7) RRIF
8) Tax Tips and Planning For Your RRSP

1. What is an RRSP?

RRSP stands for "Registered Retirement Savings Plan." RRSPs are there so that Canadian residents can save their money for retirement. Think of it as a special type of investment account designed to help you save for your retirement in the future. An RRSP is registered with the Canadian federal government, and it can hold many different types of investments.

2. Why would you want to open an RRSP?

The first and foremost reason is the tax benefits for contributing to an RRSP. The government does not tax Canadians on the funds that they contribute to their RRSP's. This way, the government encourages further saving by rewarding those who save for retirement.

I would narrow down the major benefits to 2 things:
1) All investments within an RRSP account can have tax-deferred growth. What does this mean? Normally, whatever income you make off of dividends or interest, you would pay taxes on it. However, any profits made on investments within an RRSP account in the form of interest, dividends or capital gains are not considered as taxable income for now. The contributions made to an RRSP are tax-free, and the money can compound without your taxes on the gains. RRSP investors do have to pay taxes on the profits in their RRSP only when the funds are withdrawn. This tax deferral is a great benefit because your income will be lower in retirement than in your peak earning years at a younger age.

2) The second major tax benefit comes in the form of a tax credit. This means that your taxable income is reduced by the amount you contribute. 

3. Now, how much $ can you contribute to your RRSP?
Here is a real life example. Say that you made $39,800 earned income in 2012.

• The maximum amount that the government will allow you to contribute to your RRSP in 2012 is the lower of $22,970 or 18% of your earned income (18% * $39,800 = $7164).
• So, it comes down to the lower of $22,970 or $7,164.
• Accordingly, you can contribute up to $7,164 to your 2012 RRSP.
• This means that you will only have to pay tax on $32,636 ($39,800-$7,164) of your income as you receive $7,164 in your tax credits.

4. Who is eligible to set up an RRSP?
Any Canadian residents under the age of 69 who file income tax with the Canadian government are eligible to set up an RRSP.

5. Income Splitting? - Knowledge is money.

If you are in a different tax bracket than your spouse/partner, RRSP contributions can be used to lower the total amount of taxes you and your spouse/partner as a couple must pay. The greater the difference between the two spouses' incomes, the greater the advantage of using RRSPs to income split. This way, you could save the combined taxes that you and your spouse have to pay.

Here is a real life example. You make $150,000 and your wife makes $35,000. You are in a higher tax bracket than your wife.

• If you make RRSP contributions, you can reduce your taxable income. Same goes for your wife.
• But if your wife does income splitting by making a spousal contribution, your wife will pay the same amount of taxes as she did before she made her RRSP contributions – she is basically transferring the benefits of RRSP contributions to you and she as an individual does not get any tax benefits from her RRSP contributions.
• But, you, the one in the higher tax bracket, will have less taxable income and pay less taxes.
• In the end as a couple, the combined taxes paid will be lowered.
• Morale of the Story: Definitely consider income splitting if there is a significant difference between your income and your spouse's income in the year.

6. When can I take out the money from my RRSP? - Don't even think about it.

It is not wise for you to take money out of an RRSP account before retirement because withholding taxes will apply. From $0 to $5,000, you pay 10%. From $5,001 to $15,000, you pay 20%. Over $15,000, you pay 30%.

Aside from the ridiculous amount of taxes you pay from early withdrawal, you should note that you can never re-contribute the amount of your early RRSP withdrawal. This means that if you take out $12,000 from your RRSP prior to your retirement and put the $12,000 back in at a later date, you used up your unused RRSP contribution room by $12,000, which is a major tax disadvantage in the long run.

However, there is a legitimate excuse for you to take the money out of your RRSP. By using the RRSP Home Buyer's Plan (HBP), RRSP contributors are allowed to borrow money from their RRSPs without paying a withholding tax. The maximum amount that you can borrow from your RRSP is limited to $25,000. Those who choose this option are given a 15-year period to pay back the money they borrowed from their RRSPs.

Another legitimate excuse is the Lifelong Learning Plan, which allows you to use the money to go to school. The maximum amount you are allowed to withdraw is $20,000. ($10,000 per year)

7. What happens when I'm actually retired? - The RRIF (Registered Retirement Income Fund) will be waiting for you.

Once you are retired, you can go to the financial institution holding your RRSP account, and you can start getting your cash back from the RRSP account through an annuity - This is called the Registered Retirement Income Fund.

8. Noh Review Taxation – Tax Planning: How to Strategize

Contributions for the current tax year can be made until March 1 of the following year. Here is how you strategize. If you made a large amount of income in 2012 and you know that you will make less income in 2013, you want to make sure that you make your RRSP contribution by March 1, 2013 in order to reduce the taxable income on your 2012 return. (From March 2, 2012 to March 1, 2013)

On the other hand, if you made less income in 2012 and you think that you will make higher income in 2013, you might as well wait it out and max out your RRSP contribution next year by March 1, 2014. (From March 2, 2013 to March 1, 2014) This way, you will be able to lower your high 2013 taxable income by the amount of RRSP contributions as credits.

It is also important to note that even if you don’t max out your RRSP contribution, you don’t lose that contribution room. Any unused contributions are carried forward to your future deduction limit. What does this tell us? This tells us that we can wait it out in a year of less earned income and max out our RRSP contribution room in a year of high earned income. So, you can be strategic with the timing of your RRSP contribution.

This brings us to my next point. If you are a student who isn’t making much taxable income, it may be wise for you to wait it out and accumulate your RRSP contribution room until you make enough taxable income in the future. Say that you made $12,000 earned income as a student either through summer jobs or co-op. You don’t have enough taxable income for you to actually have taxes owing to the government. If you make your RRSP contributions now, you are killing one of the main benefits of an RRSP – being able to reduce your taxable income. Hence, I would say that the timing of your RRSP contribution is critical here for your proper tax savings. But, if you are a student investor and your main focus is to have your investments compound tax-free, then your RRSP contribution can take place whenever you please.

Many people told you, “Invest into your RRSP as early as possible. Starting early is always better for you.” But, they never told you about the proper timing of your RRSP contributions. My personal advice for you is to keep accumulating your unused contribution room until your taxable income gets high enough. If you are a student, my bet is that you have many other blackholes sucking in your money. You need to think about your opportunity costs, as well.

Once you start working full-time upon graduation, you will be making a higher taxable income where you’d actually have taxes owing this time. But, in the first year of your full-time employment upon graduation, you would normally claim your accumulated non-refundable education credits (T2202), which could go up to around $30,000 (if you have never transferred it to your parents). So, the most strategic timing would be maxing out your RRSP contributions in the year of your full-time employment once you have run out of your accumulated non-refundable education tax credits. But again, it all depends on your needs and goals. If you are planning on purchasing your first home upon graduation, then there you go - start your RRSP account now so that you can take advantage of the RRSP Home Buyer's Plan.

Noh Review Taxation: Foreign Tax Credit

Today, we will briefly go over the concept of foreign tax credits.

If you paid taxes in a foreign country, you may be eligible to claim the Foreign Tax Credit. The purpose is to eliminate the double taxation of the same income by both the US and Canada. It alleviates the US taxpayer of taxes owed in the US when taxes are required on that same income in Canada. This means that the taxes payable on your US tax return will be lowered. You do not have to necessarily live or work in that foreign country in order to claim this benefit. For example, you can claim this credit if you paid foreign taxes from a mutual fund. The Foreign Tax Credit reduces your US tax liability on a dollar-for-dollar basis.

Maximum Allowable Foreign Tax Credit:

Your foreign tax credit cannot go over a certain amount, which is your US tax liability mutlipled by the percentage of your total foreign-source income divided by your total world income. Any foreign tax credit amount in excess may be carried back or carried forward.

Real Life Example: You are a U.S resident/taxpayer who has exited Canada. You have $10,000 in a Canadian Mutual Fund which pays a 5% dividend ($500 at the exchange rate of CAD $1 = USD $0.75)

Canadian Tax Implications:

• The withholding on dividends is 15%. Hence, CAD $500 * 0.15 = CAD $75 must be remitted to CRA.

U.S. Tax Implications:

• Dividend Income on US return = CAD 500 * 0.75 exchange rate = USD $375
• 25% tax bracket for non-qualified dividends = USD $375 * 0.25 = USD $93.75 tax liability
• Passive foreign tax credits on US return = CAD $75 * 0.75 exchange rate = USD $56.25.
• Use U$56.25 in foreign tax credits to offset USD $93.75 in tax = USD $37.50 Tax Liability

Noh Review Taxation: Non-Refundable Tax Credits

In this post, Noh Review will cover the non-refundable tax credits for 2012. First of all, it is critical for you to understand where these tax credits go. The basic outline looks like below:

 

Employment Income

+ Business Income

+ Property Income

+ Other Income

+ Taxable Captial Gain

- General Deductions

- Losses                          

= Income

- Division C Deductions

= Taxable Income

* Tax Rate                      

= Tax Payable

 - Division E Credits      

= Net Tax Payable

 

Here, the Division E Credits are non-refundable tax credits that we will discuss in this post today.

 

Non-Refundable Tax Credits for 2012 (Federal)

1. Basic Personal Credit: Every resident of Canada is eligible to claim this credit.

15% * 10,822

2. Married Credit (Spouse or common-law partner amount): If you are supporting your spouse or common-law partner who lives with you, and whose net income for the year will be less than $10,822, you can claim this credit.

15% (10,822-Spouse's Division B Income)

3. Equivalent to Married (ETM): There is a person who lives with you or The person is under 18 or infirm/parent

15% (10,822-Spouse's Division B Income)

4. Child Amount (Dependent Child Under 18 Years of Age): Either parent(not both) can claim $2,191 for each child under 18 who resides with both parents throughout the year. If the child is infirm, add $2,000 to the claim for that child. Any unused portion can be transferred to that parent's spouse/common-law partner.

15% * 2,191

5. Caregiver Amount: If, at any time in the tax year, you maintained a dwelling and your/your spouse's parent/grandparent (resident) aged 65 or older lived with you, you can claim this credit. This credit is reduced when the net income of the parent/grandparent exceeds a certain level.

Federal: 15% [4,402- (Relative's Division B income - 15,033)]

6. Infirm Dependent Amount: If you support an infirm dependent relative age 18+, you can claim this amount.

15% [4,402 + 2,000 Family Caregiver Amount Tax Credit - (Dependent's Division B income - 6,420)]

* Family Caregiver Amount Tax Credit (New in 2012): If the dependent is infirm, you can claim this credit. You can have an increase of $2,000 to spousal amount, equivalent-to-married, child amount, caregiver amount, or infirm dependent amount.

7.  Age Credit: If you will be 65 or older on December 31, 2012, you can claim this credit.

15% [6,720 - 15% (Division B Income - 33,884)]

8. Pension Income Credit: If you will receive regular pension payments from a pension plan/fund (excluding CPP, QPP, OAS), you can claim this credit.

15% * Lesser of $2,000 and pension income

9. Canada Employment Credit: If you are employed in Canada, you can claim this credit.

15% * Lesser of $1,095 and employment income

10. Disability/Impairment Amount: If you have an impairment in physical/mental functions that is severe and prolonged, you can claim this credit.

15% * 7,546 15% * 4,402 for disabled child

11. Tuition, Education, and Textbook Amounts (Full-time and part-time): If you are a student enrolled at a university or college and you will pay more than $100 in tuition fees, you can claim this credit. The university can be both in and out of Canada.

Tuition Credit: 15% * Total tuitions if over $100 Education Credit: 15% ($400 * full-time months + $120 * part-time months) Textbook Credit: 15% ($65 * full-time months + $20 * part-time months) If  you are a part-time student and have mental/physical disability, you receive the tax treatment of a full-time student.

12. Charitable Donations Credit: If you made a charitable donation to a CRA-registered charity, you can claim this credit with official donation receipts.

(15% of first $200) + (29% of next) Maximum donations amount is 75% of net income

13. Medical Expenses: You can claim this medical expenses credit if they were paid by you or your spouse/common-law partner.

15% of medical expenses which exceed the lesser of $2,109 and 3% of Division B Income If medical credit is more than $10,000, deny impairment credit.

14. Fitness for Children: You can claim to a maximum of 15%* $500 per child the fees paid in 2012 relating to the cost of registering your child in a prescribed program of physical activity. Children less than 16 years old

15. Artistic, Cultural and Recreational Activities for Children: You can claim to a maximum of 15% * $500 per child the fees paid in 2012 relating to the cost of registration or membership of your child in a prescribed program of artistic, cultural, recreational or developmental activity. Children less than 16 years old

16. Home Buyer's Amount: You  can claim an amount of 15% * $5,000 for the purchase of a qualifying home made in 2012, if You or your spouse acquired a qualifying home. This is your first home and you are a first-time home buyer.

17. Public Transit Passes Credit: You can claim an amount of 15% * total public transit passes expenses.

Amounts transferred from your spouse/common-law partner: If your spouse will not use all of his/her age amount, pension income amount, tuition, education and textbook amounts, disability amount or child amount on his/her income tax return, you can claim the unused amount. Cannot transfer medical, charitable donations or CPP/EI amounts

Amounts transferred from a dependent: If your dependent will not use all of his/her disability amount on his/her income tax return, you can claim the unused amount. If your dependent child/grandchild will not use all of his/her tuition, education and textbook amounts on his/her income tax return, you can claim the unused amount.

It is interesting to note that some of these non-refundable credits have a clear purpose, and they are for the benefit of the society. For example, home buyer's amount credit is available in hopes of encouraging more people to buy their first houses. The public transit passes credit is another great example. You can basically take back 15% of what you paid for your bus fares. This could be interpreted as the Canadian government's efforts in attempting to reduce air pollution and greenhouse gas emissions. Increasing the use of public transit, including buses, subways and commuter trains, will help ease traffic congestion and reduce air pollution. This tax credit makes public transit more affordable for Canadia residents.

 

But if you are a student, these non-refundable credits are not as meaningful because your net income is likely low anyways. Again, these are non-refundable credits for the year, so you cannot technically get these back as cash. In other words, you can only deduct these amounts from your net income, and if your net income is low, these credits are useless realistically. My assumption is that once you start working full-time, you are going to be looking for every possible non-refundable tax credit in order to minimize the tax that you pay to CRA.

Noh Review Taxation: Residency

As some accountants are getting ready for the tax season, this post will help clarify some of the Canadian taxation concepts regarding residency.

Residency for Individuals

• The Canadian Income Tax Act imposes taxes based on Residency. This means individual who currently reside in Canada, who may or may not be citizens.
• Individuals who are not residents of Canada but are employed in Canada, carry on business in Canada or dispose of taxable Canadian Property are subject to Canadian taxation.
• Canadian Residents are taxed on their worldwide income, regardless of which country the income was earned in. To avoid double taxation, Canada has negotiated a number of international reciprocal tax agreements.
• Key Principle: The country in which income is earned has priority in taxing that income and the country of which the payer is a resident allows all or some part of the foreign tax paid as a credit against the domestic tax.

1) Full-time resident: taxed on his worldwide income for a full year

• Deemed: Sojourned in Canada for 183 days or more OR Have the characteristics of a non-resident
• Common Law: Continuing State of relationship with Canada

• Maintaining a dwelling
• Immediate family remaining in Canada
• Maintaining personal property and social ties in Canada
• Furniture, clothing, cars, medical insurance, seasonal residence, employment/investment with Canada, retirement savings plans, credit cards and securities accounts, landed immigrant status, passport, license, membership, retention of Canadian mailing address, telephone listing and newspaper subscriptions

2) Part-Year Resident: Taxed on his worldwide income earned during the part of the year he was resident in Canada

• Clean Break: Leaves Canada during a year and severs all ties with Canada (with a spouse and dependants)
• Fresh Start: Comes to Canada during a year after permanently severing all ties with the previous residence

3) Non-Resident: Taxed on his Canadian-source income

• Employed in Canada [Continuous business activity: Carried on business in Canada or Disposal of taxable Canadian Property]
• E.g. A non-resident selling something in Canada through a salesperson = carrying on business in Canada
• Through an independent contractor (Canadian retailer/wholesaler) = not carrying on business in Canada = not taxable in Canada on business income earned in Canada
• “A person who is a non resident for the whole year cannot be a part-time resident. To be a part time resident, there must be a period in which the person was resident, in the sense of a full-time resident, and a period in which the person was non-resident.”

Canada-U.S Tax Convention: Exists to avoid double taxation or tax avoidance. Exempts a CDN resident from U.S taxation on salaries, wages, and other remuneration if:

• Remuneration < $US 10,000
• Present in the U.S. for <183 days

Only Taxed in U.S if he had a permanent establishment in U.S:

• More than 50% of gross active business revenues in U.S
• Or business is for U.S. customers
• Defined as a fixed place of business through which business of a resident of (a country) is wholly or partly carried on.
• Places of management,  a branch, and office, a factory
• Individual who is resident in Canada, would only be taxed in the U.S if the individual has or had a “permanent establishment” regularly available to him or her in the U.S. The tax amount is capped at the income attributable to the permanent establishment in the U.S.

Residency for Corporations: Depends on resident vs. non-resident

Corporate Residence depends on:

• Deemed Resident if incorporated in Canada after April 26, 1965
• Common Law: Central management and control are in Canada; Real business is carried on in Canada; Permanent establishment in Canada
• If incorporated before 1965, still deemed resident if it was resident by the common law principle of control management and control; it carried on business in Canada after 1965