The 4 Ds of tax planning

There’s a reason almost every strip mall and professional building has an accountant or tax professional. Taxes are hard. Even Einstein had problems with them and he was a genius. 

The hardest thing in the world to understand is the income tax. 

– Einstein

In fact, the Canadian Income Tax Act or ITA is about 3,000 pages long and well over one million words. And, it’s subject to change based on the whims of whoever is in power. Then the Canadian Revenue Agency (CRA) jumps into the mix with information circulars, interpretation bulletins and technical interpretations that only add to the complexity. 

And we haven’t even started talking about provincial taxes.

With all that complexity, how are you supposed to set up your spending (and earning) to make the most sense when April comes around? Chances are, you don’t have the time to get your CPA before then. 

We’ve got good news. While CPAs have to dive into that ocean of minutia, you don’t have to drown in the details just to set yourself up well for tax season. And when you can ignore the details, taxes are actually quite simple.

In fact, you can sum up a good tax strategy in four words, each of which conveniently starts with the letter D:

• Deduct
• Decrease
• Defer
• Divide

But, before we get into each of those, we’re going to have a quick refresher on how the Canadian tax system works.

How do Canadian taxes work? 

In Canada, you pay federal and provincial income tax on income from both wages and investments. These taxes are progressive, which means tax rates increase as income rises. Each tax rate is called a bracket. These tax brackets change between provinces and vary from year to year, so we’ll skip over the specific percentage so we can avoid details that could change next year.

Example

Meet Mrs. Sample. She makes $80,000/year. Let’s see how much taxes she’ll pay in the Canadian tax system.

For simplicity’s sake, in this example, we’ll say the combined federal/provincial tax rate* for the first $30,000 earned is 15%. The next $30,000-$60,000 of income is taxed at 20%. The next $30,000 at 25%, and so on. 

So, Mrs. Sample will pay:

• $4,500 on the first $30,000
• $6,000 on the next $30,000
• $5,000 on the last $20,000

All in, she’s paying $15,500 on her income.

However, that number’s not set in stone. Your tax burden can be reduced in a variety of ways, without reducing your income. That’s where the 4 Ds of tax planning come in.

* You can find both federal and provincial tax rates on Canada.ca.

Deduct

One of the most effective ways to reduce your tax burden is by deducting certain expenses from your income. This decreases your income in the eyes of the CRA, and as a result, the amount you need to pay.

Deductible expenses include:

• Child care 
• Disability support
• Self-employment expenses

A complete list of qualifying income deductions is available on the Canada.ca website. 

Example

Let’s go back to Mrs. Sample. When she is getting ready to pay her taxes, she finds $10,000 in expenses she can deduct from her income. 

So, the CRA only counts $70,000 of her income as taxable. So instead of having $20,000 in the highest tax bracket, it’s reduced to $2,500.

This reduces her tax burden by $2,5000.

Decrease

Of course, decreasing your tax burden is the point of this whole article. But in this section, we’re talking about decreasing the taxes you owe on each dollar. This is done through tax credits. These allow you to reduce your tax burden after calculating your taxes. 

Tax credits come in one of two types:

• A refundable tax credit can reduce your tax burden below zero, i.e. the government will owe you money.
• A non-refundable tax credit can only reduce your tax burden to zero.

Example

Mrs. Sample’s son is in University. He has a part-time job with an income of $10,000. In this example, that means he owes $1,500. Because he’s in university, he can claim a non-refundable 15% tax credit on his tuition, which was $15,000 for the year. So, he has $2,250 in tax credits at his disposal. But, because they are non-refundable, the tax credits simply reduce his tax burden to $0.

 If they were refundable, the government would owe him $750 on his tax return.

Other tax credits include:

• Charitable donations
• The first-time home buyers’ tax credit
• Using TFSAs to shelter investment income

Defer

Deducting and decreasing both directly impact how much you owe to the government. Deferring, on the other hand, doesn’t change the amount, it just changes when you pay it. A great example of that is an RRSP. When you put money into your RRSP, you shelter it from income tax until you take it out, thus deferring your taxes until later.

Example

Mrs. Sample has decided to contribute $83.33 a month ($1,000/year) to her RRSP. That means instead of paying taxes on the full $80,000 she made last year, she pays tax on $79,000 this year and defers the tax (which would be $250) on the last $1,000 until retirement.

The benefits of deduction are obvious, but the benefits of deferring are more complicated. For Mrs. Sample above, she deferred the 25% taxes on that $1000 until she retires. So, she’ll end up paying taxes on it when she’s on a fixed income. That may seem scary, but it also means that she’s paying income tax on that income when she’s making less money. So, if she’s only making $59,999 in retirement, she’ll only pay $200 when she takes it out, saving her $50.

Deferral can also be beneficial because inflation decreases the value of your money in the future. So, by deferring paying taxes today, you can use tomorrow’s less valuable dollars to pay your taxes. 

However, deferral can also be risky, as tax brackets change over time, which may mean that money you defer today will move from a lower tax bracket to a higher one, increasing your tax burden.

Besides RRSPs, common deferral mechanisms are:

• Keeping money in an incorporated business
• Investments where you pay the capital gains tax only after they are sold

Divide

Every person is subject to their own tax rate. So even if you make $200,000 and your spouse makes $2, your spouse pays taxes based on their own tax bracket. If this was the case, you could save a lot of money by simply attributing some of your income to your spouse.

Example

Mrs. Sample makes $80,000/year. Her husband is a stay-at-home dad. In our example world, Mrs. Sample pays $15,500 in taxes each year. But, if she were able to divide her income between her and her husband, they would both appear to make $40,000/year. That means each would pay 15% on the first $30,000, and then 20% on the next $10,000, which would equal $6,500 each. So as a family, the Samples would pay $13,000. That’s a savings of $2,500.

Unfortunately, income splitting is not that simple. We can’t simply hand over our income to our spouse or kids. There are attribution rules that prevent these, and most types of income splitting. However, there are tools you can use to mimic income splitting.

• Spousal RRSPs – you can contribute to your spouse's RRSP and deduct the income from your taxable income. 
• RESPs – RESPs shelter investment income, so while you can’t deduct the investment, the income from any investments in an RESP is taxed in your child’s hands (who, as a student, probably doesn’t have much income).
• TFSAs – You can fund your spouse's TFSA, which effectively doubles the amount you can invest inside the TFSA.
• Pension income splitting – You can split qualifying pension income with your spouse.
• Prescribed rate loans – you can’t simply gift income to a family member, but you can loan them money at an interest rate as prescribed by the CRA.
• Paying family members from a business – if you employ a family member in your business you are allowed to pay them a reasonable income.

There are other, more complex ways to split income within your family, but these can become needlessly complex and may carry some risk. So they should be weighed against any benefits before embarking on such strategies.

Better tax planning

Donating (another D) is often thought of as the main way to lower your tax burden, but as we’ve shown above, it’s just one small tool to have in your tax planning tool kit (it falls under decrease). If you start this year planning to use each of the tools available to you, it will help your accountant decrease your tax burden at the end of the year.