Tax Planning

Tax Brackets

In Canada, we have a progressive tax system.  This means that the higher your income the greater your tax rate.  The following table shows the tax rates for 2020.

Income Level Federal Alberta Combined
$1 – $48,535 15% 10% 25%
$48,536 – $97,069 20.5% 10% 30.5%
$97,070 – $131,220 26% 10% 36%
$131,221 – $150,473 26% 12% 38%
$150,474 – $157,464 29% 12% 41%
$157,465 – $214,368 29% 13% 42%
$214,369 – $314,928 33% 12.5% 47%
$314,929 + 33% 15% 48%

Your marginal tax rate is the combined tax rate of your last dollar earned.  This is the cost (in tax) of earning additional income.  This is also how much tax you save with tax deductions (such as pension or RRSP contributions). 

Employment Expense Tax Credit

When you receive employment income, you are entitled to an employment expense tax credit which effectively shelters the first $1,245 (in 2020) of employment income from tax.

Maximize RRSP Contributions

If you are going to be in a lower tax bracket in retirement, you should make your maximum RRSP contribution while you are working.  You will get a tax deduction now at your current tax rate and you will be able to take the money out later when you are in a lower tax bracket.

Spousal RRSP

The higher income spouse should consider contributing his/her RRSP amount to an RRSP for the lower income spouse.  This spousal RRSP will not affect the lower income spouse’s own RRSP contribution room. When the money is withdrawn, it will be taxed in the lower income spouse’s hands.

Pension Income Tax Credit

When you reach age 65 you can transfer your RRSP to either a RRIF or annuity.  These payments would qualify for the Pension Income Tax Credit, which effectively shelters the first $2,000 of pension income from tax.

If you have pension income from an employer sponsored pension plan, it will qualify for the tax credit at any age.

If you want to start a pension as early as age 55 to qualify for this tax credit, you can contribute $2,500 per year to the Saskatchewan Pension Plan and purchase an annuity from them at age 55.  It would take between $40,000 and $50,000 to purchase an annuity of $2,000 per year (paid monthly).

Maximize TFSA Contributions

You should make your maximum contributions to your Tax Free Savings Accounts.  This year (2020) you have an additional $6,000 that you are able to contribute (this amount is periodically adjusted for inflation).  You will not get a tax deduction for the contribution, but the capital can grow tax free.  When you withdraw funds, you will not have to pay tax on the withdrawal (whether income or capital).  Any unused contribution room (since 2009 or turning 18) is carried forward until death.  Any withdrawals are added to future TFSA contribution room.  For 2020, the accumulated contribution room is $69,500.

Non-Registered Investments

If you own any investments outside your tax-sheltered plans, the type of investment income you receive and the amount of income you earn has an impact on the rate of tax that you will pay. 

Interest Income

Interest is taxed at your marginal rate.  In Alberta, the tax rate on interest earned below $48,535 is 25%.  Between $48,536 and $97,069, the tax rate on interest is 30.5%.  Between $97,070 and $131,220, interest is taxed at a rate of 36%.  Between $131,220 and $150,473, interest is taxed at a rate of 38%.  On income above $150,473, interest is taxed at a rate of 41% to 48%.

Rental Income

Net rental or lease income is taxed at the same rate as interest income.  Against the gross rents you can deduct your direct costs as well as capital cost allowance.  Significant improvements to the property are added to the cost of the property.  They are not available as a deduction against other income.

Other Income

Foreign dividends and income from limited partnerships or income trusts are taxed at the same rate as interest income.  Any foreign taxes paid can be used as a foreign tax credit or tax deduction.

Dividend Income

Dividends from a Canadian corporation are tax favoured.  Through the dividend gross-up and tax credit, you pay tax at about one half of the rate you would if it were interest income.  In Alberta, the tax rate on dividends below $48,535 is 0% (the dividend tax credit offsets the tax on the dividend income).  Between $48,536 and $97,069, the tax rate on dividends is about 8%.  Above $97,069 to $131,220, dividends are taxed at a rate of about 15%.  Above $131,220 to $150,473, dividends are taxed at a rate of about 18%.  On income above $150,473, dividends are taxed at a rate of 22% to 32%.  With the personal exemption, an individual could earn about $50,000 of Canadian dividends and pay no tax if there was no other income earned during the year.

Capital Gains

By investing in equities (or real estate) you may also achieve a capital gain (or loss) on the sale of these investments.  Only one half of capital gains are taxable so that the effective tax on capital gains is one half of the rate charged for interest income.  In addition, the tax is deferred until the capital asset is sold.

In Alberta the effective tax rate on capital gains in the lowest tax bracket is 12.5% and in the second tax bracket is 15.25%.  In the third tax bracket, capital gains are taxed at 18%.  In the higher tax brackets, capital gains are taxed at 19% to 24%.

Return of Capital

By investing in certain structured investment trusts you may receive a combination of income and return of capital payments.  The income (interest, dividends or capital gains) is taxed at your marginal tax rate.  The return of capital payments are not taxed in the year of receipt.  The amount received is deducted from the original cost of the investment.  When the investment trust is sold, a capital gain (or loss) is calculated based on the new (lower) cost base. 

Some financial services companies market mutual funds where the payment you receive (usually monthly) is considered a return of capital.  You do not have to pay tax on the money you receive.  When you sell your units then a capital gain or loss is calculated.  Each year the fund must distribute its income and realized capital gains.  This distribution is usually reinvested in more units of the fund, but you will have to pay tax on the income.

Summary

The effective tax rates on investment income are as follows:

Income Range Interest Income Rental Income Foreign Dividends Canadian Dividends Capital Gains
$0 – $48,535 25% 25% 25% 0% 12.5%
To $97,069 31% 31% 31% 8% 15%
To $131,220 36% 36% 36% 15% 18%
To $150,473 38% 38% 38% 19% 19%
To $157,464 41% 41% 41% 22% 20.5%
To $214,368 42% 42% 42% 23% 21%
To $314,928 47% 47% 47% 30% 23.5%
Over $314,928 48% 48% 48% 32% 24%

We suggest that you use tax effective investments such as Canadian dividends and capital gains in your tax paid savings accounts.  Higher taxed investments such as bonds or bond funds, REITs and foreign stocks should be held in your RRSPs or TFSAs.

Income Splitting with Spouse

To the extent permitted, your family finances should be arranged to ensure that investment income is taxable in the hands of the individuals with the lowest marginal tax rate.

If the lower income spouse has a lower marginal tax rate than the higher income spouse, then the higher income spouse should pay all living expenses allowing the lower income spouse to accumulate funds for investments or future asset purchases.

This strategy includes having the higher income spouse pay for any income tax liability of the lower income spouse’s as well as their RRSP and TFSA contributions as these payments avoid income attribution.

Pension Sharing

Under current tax legislation you are able to “split” your qualifying pension income.  Up to 50% of pension income can be transferred from (generally) the higher income spouse to the lower income spouse.  This includes employer sponsored pension payments as well as RRIF and LIF income after age 65.

There is no cash transferred from one spouse to the other, only an accounting entry on your tax returns.  The amount can change each year or be stopped completely in certain years.  The actual amount can be determined each year when you prepare your tax returns.

Split CPP

Once both of you are eligible to receive CPP, you can both apply to have your pension split equally between you.  This way, income that would be taxed in the higher income spouse’s hands can be shifted to the lower income spouse’s and be taxed at a lower tax rate.  This may reduce the tax burden of the family.

This is different than pension sharing as described above.  There is an actual reduction of the higher income spouse’s CPP that would be paid to the lower income spouse.  Once started, it will continue until you stop it (or one of you dies).

Lend to Spouse for Investing

 If the lower income spouse does not have any income, it is difficult to accumulate capital in their hands.  If the higher income spouse were to gift money to the lower income spouse, the income attribution rules would come into effect.  These basically state that income earned on an investment must be taxed in the hands of the individual who “owns” the capital.

If the higher income spouse loans money to the lower income spouse at the “Prescribed Rate” then the income would not be attributed back to you.  However, lower income spouse would have to pay interest on the loan at 2% (today’s “prescribed rate”).  This interest income must be included on the higher income spouse’s tax return.  The investment income earned would be taxed in lower income spouse’s hands. Once the loan has been set up, the interest rate continues until the loan is paid off.  If you are getting a higher than 4% return on your investments, it may make sense for the higher income spouse to lend their capital to the lower income spouse in exchange for the 2% interest payment.

Second Generation Income

One exception to the attribution rules is second-generation income.  If the higher income spouse gave the lower income spouse $20,000 and they invested it at 5%, the higher income spouse would have to pay the tax on the $1,000 of income generated in the first year.  But that $1,000 now actually belongs to the lower income spouse, so any income generated by investing that $1,000 would be taxed as their income.  Over time, this would create a large investment pool in the hands of the lower income spouse that would be taxed at a lower tax rate.

Spouse with No Income Could Borrow to Invest

Another way around the attribution rules is for the lower income spouse to borrow money for investment.  Because the lower income spouse borrowed the money, any investment income will be taxed in the lower income spouse’s hands.  If you subsequently pay off some or all of the loan, the attribution rules do not apply, as you have not given the lower income spouse money for “investment” only for debt reduction.

Income Splitting with Minor Children

To reduce the tax burden to the family as a whole, it makes sense to have the investment income taxed in the hands of the person in the lower tax bracket.  Your child can also be a taxpayer.  Unfortunately, Canada Revenue Agency (CRA) does not allow parents to transfer funds to children for investment purposes.  If money is transferred to a minor child, and that child invests the money, CRA will attribute the investment income back to the transferor.

The attribution of the income continues until the money is transferred back.  However, any second-generation income is taxed in the hands of the recipient.  As an example, you could give your child $20,000 to invest.  If he invests the money at 5%, the $1,000 per year of income would be taxed in your hands.  The $1,000 could be invested again at 5% and the $50 of second-generation income would be taxed in his hands.

If your child invests the money in dividend paying Canadian stocks, then the first generation income would be taxed in your hands at a low rate and any second generation income would be taxed in the child’s hands at an effective rate of zero.  Also, any capital gains realized by the child from this money (whether first or second generation) will be taxed in his hands.

If you loan money to your child at the “Prescribed Rate” then the income would not be attributed back to you.  Your child will have to pay you interest on the loan at 2% (today’s “prescribed rate”).  This interest income must be included on your tax return.  The investment income earned would be taxed in your child’s hands. Once the loan has been set up, the interest rate continues until the loan is paid off.

Canada Child Benefit

The Canada Child Benefit cheques should be put in a separate bank account for the children.  This way any investment income generated from this money will be taxed in the children’s hands, and as long as they do not earn over $13,229, no tax will be payable.

The money can be used to buy term deposits, Canada Savings Bonds or mutual funds.  Over the long term, a mutual fund that invests in the stock market has historically outperformed interest-bearing investments.

Income Splitting with Adult Children

Gifting to children over the age of 18 has no income tax consequences to you other than reducing your capital and therefore your future taxable income.

If they use the money to pay off debts or buy personal assets, then there would be no income tax consequences for them.  If they contribute the money to their TFSA, then they will not have to pay tax on the investment income.  If they contribute money to their RRSP, they will get a tax deduction and defer the tax on the investment income until retirement.

If they invest the money outside of tax shelters, your children will have to pay tax on any investment income that they receive from the capital.  If they are in a lower tax bracket than you are then they will pay less tax than you and there will be more money left over to pay for current expenditures (like their education).

Borrow Only to Invest

If you are going to borrow, it is better to borrow for investment purposes rather than for personal items.  Any interest that you pay on an investment loan is tax deductible.

By accumulating funds outside your RRSP, you could make a lump sum payment on your mortgage or car loan.  When these debts are paid down or off, you could then re-finance the loans and use the borrowed funds for investment purposes.  This way the new mortgage or car loan interest would be tax deductible.

It also makes sense to save for your personal goals rather than borrowing.  For the purchase of your next car, you can use your savings to pay for the vehicle then borrow to replace your savings.

Take Investment Deductions

To look at other ways of reducing your taxes, you should be aware that all expenses associated with earning investment income are tax deductible.  These would include accounting fees and any investment counsel fees.

Take Other Deductions and Credits

Union dues and professional association fees are tax deductible.  Child care expenses (day-care, summer camps, etc.) are deductible for the lower income spouse.  Moving expenses are deductible if you change working locations and you are now more than 40 kilometers close to your new work location.  Alimony and spousal support are tax deductible for the payor but taxable to the recipient.

Medical expenses exceeding 3% of your net income ( or $2,397 in 2020) are eligible for a tax credit.  It makes sense for the lower income spouse to claim the expenses as they can usually claim more.

Charitable Donations

Donations to registered charities create a tax credit of 25% on the first $200 of gifts and 50% on all amounts above $200 (to a maximum of 75% of your net income).  You can carry forward your donations for up to five years.  It makes sense for one spouse to claim all the donations on one tax return.

If you gift your investment (stocks, mutual funds, etc.) to a charity, your capital gain will be exempt from tax but you will receive a donation receipt for the full value of the investment donated.  If you want to make a charitable donation, it is more tax effective to donate your investment than to donate cash.

Clawbacks at Age 65

When you turn 65, you become eligible for Old Age Security and an Age Exemption.  Old Age Security is $7,362 (in 2020) and the Age Exemption is $7,637 (in 2020).  Effectively the age exemption cancels out the tax on the OAS.  If you earn too much income, you begin to lose the age exemption (at an income level of $38,508 in 2020).  This means that you will have to pay tax on your OAS.  The age exemption is reduced by 15% of your income above $38,508 until it is completely gone at an income level of $89,421.  If you make more than $79,054, then you will lose some of your OAS.  The OAS is reduced by 15% of your income above $79,054.  It is completely clawed back at an income of $128,137.

Once you are 65, these clawbacks increase the effective tax rate that you pay.  For income earned below $38,508 the combined federal provincial tax rate is still 25%.  On income earned between $38,509 and $48,535 the tax rate and clawback works out to a combined rate of 28.8%.  Any income earned between $48,536 and $79,054 is taxed at an effective rate of 34.3%.  If you make more than $79,054 but less than $97,069, the clawback of OAS makes your tax rate about 40.9%.  Income of more than $97,069 but less than $128,137 is taxed at an effective rate of 45.6%.

Once you have paid back all your OAS, your effective tax rate drops back to 36% (to $131,220) and then 38% to 48% for income above $131,220.

In Alberta, the effective tax rates on investment income after 65 are as follows:

Income Range Interest Income Rental Income Foreign Dividends Canadian Dividends Capital Gains
$0 – $38,508 25% 25% 25% 0% 12.5%
To $48,535 29% 29% 29% 5% 14.5%
To $79,054 34% 34% 34% 13% 17%
To $97,069 41% 41% 41% 24% 21%
To $128,137 46% 46% 46% 28% 23%
To $131,220 36% 36% 36% 15% 18%
Over $131,220 38% to 48% 38% to 48% 38% to 48% 18% to 32% 19% to 24%

If you are going to be subject to these clawbacks, you should consider withdrawing funds from your RRSPs prior to 65.  You should also consider using tax effective investment income after 65 to minimize the clawback of OAS and/or the age exemption.