Tag: Tax rates

Basic Personal Amount – Will BPA changes truly provide tax relief

The federal government recently put a key piece of their tax platform in place: an increase in the basic personal amount (BPA). This is expected to lower taxes for close to 20 million of us, and eliminate any federal tax liability for almost 1.1 million Canadians.

To deliver on this promise, the government will increase the BPA to $15,000 by 2023. On the face of it, that’s a nice, round, substantial figure, and no doubt many of us will experience tax savings. Still, to give it some proportionality and context, let’s take a closer look to understand how, when, to whom, and to what extent this will provide tax relief.

DEDUCTIONS AND CREDITS

Most non-tax professionals likely don’t pay too much attention to the difference between a tax deduction and a tax credit. Both can reduce a person’s tax bill, but in a very real sense they are applied at opposite ends of the income spectrum.

A deduction reduces the amount on which tax is calculated. Because we have a progressive personal tax system (i.e., higher rates applying to income at higher brackets), a deduction reduces tax exposure at a person’s uppermost or marginal rate.

In terms of tax credits, a non-refundable credit reduces your initially calculated tax due, whereas a refundable credit is more like a subsidy in that it is paid even if you don’t owe tax. In either case, a maximum amount is legislated for a given purpose, against which the appropriate credit rate is applied. With a few exceptions (mainly charitable and political donations), the credit rate most often is at the lowest bracket rate. For federal tax calculations the lowest rate is 15%, but a person’s own income dictates the marginal rate, which may be as much as 33%.

Connecting those dots, a deduction is generally more valuable than a credit.

The most common non-refundable credit is the basic personal amount, sometimes called the basic personal credit.

Either way, it’s referring to the same thing — effectively negating tax on income from zero up to the set level. For instance, when you file your upcoming return for the 2019 taxation year, you’ll claim this credit on your first $12,069 income. At the 15% rate, the value of the credit is $1,810.

While it may seem an obvious point, note that the amount is larger than the credit value, since it is multiplied by the credit rate. Keep this in mind as we turn our attention to the change in the amount, and contemplate the value of that change.

ENHANCED BPA

Over the course of the next four years, the BPA will be bumped beyond its usual inflation indexing until it reaches $15,000 in 2023. The rollout schedule is shown in the first three columns of the table here, reproduced from the Department of Finance backgrounder. The two right-hand columns are my own calculations for the sake of some analysis to follow.

The additional BPA will initially yield $140 in annual tax savings, rising to about $300 in 2023, as featured in official communications. In that last year, the $15,000 amount will equate to a full value for the BPA of $2,250, a 13% improvement over what current indexing would have given.

However, it will be almost four years until early 2024 tax filing when that extra $300 may be claimed. Using the approximate 2% indexing employed by the Department of Finance, that discounts back to about $277 in current dollar value.

To be clear, I’m critiquing, not criticizing; my aim is to couch expectations of the practical implications for individual and household budgets. That last point is especially important, as there are parallel changes to the spousal and eligible dependant amounts, the effect of which will be to double the impact to as much as $600 for families claiming either of those credits.

INCOME CEILING AND TIME HORIZON

Not everyone will enjoy this enhanced BPA. Extra components will be added to the BPA definition to reduce the enhancement as income enters the 29% fourth bracket, until it is eliminated for someone whose income exceeds the 33% top/fifth bracket. For 2020, those thresholds are $150,473 and $214,368. For your curiosity, a $300 loss across this range is a clawback contribution to a marginal effective tax rate of just under 0.5%.

The BPA and brackets will continue to increase each year according to the existing indexation formula, but the BPA enhancement will remain at $15,000 after 2023. This means that the value of the enhancement will continually erode each year thereafter. Using that 2% index factor as a proxy, the BPA would overtake the enhancement by about 2030. Whether this will still be a feature of our tax system a decade from now is anyone’s guess.

RRSP over TFSA as default choice – Analyzing marginal & average tax rates

Published version: Linkedin

There’s a scene in Doc Hollywood where Michael J. Fox, the fresh med school grad, is readying to airlift a young patient out of the small town for emergency heart surgery. Just before liftoff, the aging local doctor shows up and hands the boy a can of pop – Sip, burp, everybody go home.

Theatrics aside, there’s a lesson here for the RRSP vs. TFSA debate.

Since its introduction in 2009, the TFSA has proven to be a powerful tool that opens up countless possibilities for bettering our financial lives. However, when it comes to retirement savings, the tried-and-true RRSP should be the default choice for most of the population. Here’s why.

Tax treatment IN, tax treatment OUT

Both RRSP and TFSA give you tax-sheltered income and growth on the investments within them. The key difference is what happens on front and back end:

  • RRSP deposits are pre-tax, while withdrawals are taxable;
  • TFSA deposits are post-tax, but withdrawals are non-taxable.

Of course, it’s often said that RRSP contributions are tax-deductible, the appeal being the desired refund. However, to convert that to being truly “pre-tax”, all such refunds (and refunds on refunds) must in turn go into RRSPs. That’s already handled through reduced withholding tax on a work-based group RRSP, but with an individual RRSP that’s your own ongoing responsibility.

Base comparison

If your income is taxed at the same rate when contributing and withdrawing, you will net the same amount of spendable cash whether you use the RRSP or TFSA. Using $100 at a 40% rate and a 10% one-year return (for simplicity, not reality), here is what each yields:

  • RRSP  $100 deposit + $10 return = $110 taxable, netting $66 spendable
  • TFSA $60 deposit + $6 return = $66 spendable

If you are at a higher tax rate going in than out, the RRSP will do better, and vice versa. If you change the example to 40% in and 30% out, the RRSP nets you $77, but the TFSA is still $66. And if your later rate is instead 50%, RRSP nets $55, and once again TFSA $66.

Is it really that simple?

“Same rate” – Marginal or average?

Having made the point about taking care in managing the deductibility of an RRSP contribution, we can’t lose sight that it is indeed a deduction. The benefit is that your RRSP contribution comes off the top at your marginal rate, saving you tax at the highest rate you would otherwise face.

On withdrawal in your later/retirement years, the appropriate measurement is arguably (I’ll come back to this) your average tax rate. Average tax rate is total tax divided by total income. In a progressive tax system where there is more than one bracket, average rate will always be lower than marginal rate.

That in mind, imagine for a moment that there were no contribution limits for either plan type. Even if you were at the same (indexed over time) income level in retirement, the RRSP route would do better than TFSA, because the average rate out must be less than the marginal rate in.

But what’s your own average rate?

In truth, not all your retirement income will come from RRSP savings alone, which brings me back to the arguable point about whether to use the average tax rate as stated above.

Once you begin your CPP and OAS, you have no further discretion whether or not they are paid from year to year. That then forms your foundation lower bracket income, on top of which your RRSP (in the form of a RRIF or annuity draw) is layered. In that case, the applicable average rate should be calculated on the income above this non-discretionary floor. Still, as long as there are at least two brackets, and you were the higher on contribution,  this modified average rate will be below your original marginal rate.

It gets more complicated if the OAS clawback comes into play, adding about 10% net to the marginal effective tax rate (METR). But even if you were entitled to maximum CPP and OAS of about $20K, you’d be progressing up through low to mid brackets until you hit the OAS clawback as you neared $80K. Nonetheless, according to my calculations, average rate would still be materially below marginal rate at full clawback around $130K.

Default choice, not dogmatic requirement

To repeat, the point here is that RRSP is the default choice, but that it could be displaced based on other factors.

Factors that bolster RRSP include: the fact that most people live on a lower income in retirement, meaning both lower marginal and average rates; spouses using pension income splitting to bring down their combined average tax rate; and, the availability of the pension credit.

Comparatively, the TFSA may be favoured when: an income earner is at low bracket at saving age; there are already significant RRSP assets; or, a large inheritance/winfall has arisen that affects the timing and/or amount of required drawdown from existing savings.

It’s the financial advisor’s job to identify these and other relevant factors, assess the effect of each, and discuss with their client how to maneuver with that knowledge. In reality, it’s more about proportionality than a binary RRSP vs. TFSA decision. Having an appreciation for the technical underpinning will make for better-informed choices and greater confidence to stay the course.

December 2015 federal income tax changes

After recalling Parliament in the first week of December, the new government acted quickly on its key tax promises. Some introduced measures were already known from the Liberal platform, some only became clear in the announcement and still more were consequent on those other changes.

This summary draws from the published Explanatory Notes that accompanied the Notice of Ways and Means Motion to amend the Income Tax Act (Canada).

Rates for taxation years after 2015

The so-called “middle class tax cut” will be effective for the 2016 tax year. This is a reduction in the rate applying to income in the second tier, from 22% to 20.5%. Concurrently, a new top 33% tax-rate bracket is added. For 2016, the federal brackets are as follows (to be indexed in subsequent years):

• Up to $45,282        15%

• Up to $90,563        20.5%

• Up to $140,388      26%

• Up to $200,000 29%

• Over $200,000 33%

Tax-free savings accounts

There had been some uncertainty as to what the “rollback” of the $10,000 tax-free savings account (TFSA) room might mean. As it turns out, that amount will stand as the TFSA dollar limit for 2015 alone, whether or not contributions were made during 2015. That is, it will carry forward for those who had not used it in the year.

The TFSA dollar limit for 2016 will be $5,500, and the indexing formula is reinstated. The reinstated calculation refers back to the $5,000 amount in the 2009 base year, with the calculation rolling forward from then. It effectively disregards the $10,000 amount in 2015; or put another way, contributors are not penalized in future years for having been granted a large amount of TFSA limit in 2015.

Unlike registered retirement savings plan room that changes annually, the TFSA limit is indexed periodically. It is, however, based on an underlying reference figure that is indexed annually. Once that reference figure rounds up to the next $500 increment, the limit is increased that year and following. It increased to $5,500 in 2013.

Deduction by individuals for gifts

The introduction of the new 33% bracket for income in excess of $200,000 has implications for the tax credit for charitable donations. Currently, the credit is worth 15% on the first $200 of annual donations and 29% on amounts over $200. Respectively, those were the prevailing lowest and highest bracket rates.

The addition of the 33% bracket would have automatically increased the over-$200 credit rate from 29% to 33%. As the credit rate applies irrespective of the income of the donor/taxpayer, this would have made an already generous benefit even more so.

Instead, from 2016 on, the higher 33% credit rate will be available only to the extent that a taxpayer has income over $200,000. This assures that high-income taxpayers will not be deterred from donating, while preserving the value of the credit for others. To illustrate how this will work, suppose a person with taxable income of $215,000 donated $20,000. Only $15,000 would be entitled to the 33% credit rate, with $4,800 at 29% and $200 at 15%.

Corporate-personal tax integration 

The proper functioning of our tax system is based in part on the integration of personal and corporate taxes. Absent such a coordinated approach, the use of a private corporation could lead to unintended tax benefits. Integration is carried out using a number of mechanisms at the corporate level and on passing income from a corporation to an individual. The underlying theory is to impose a tax cost that roughly emulates the corporation as a top-bracket personal taxpayer.

The increase in the top personal tax rate from 29% to 33% necessitates adjustments to the rates used in these integration mechanisms. For a private corporation (including a Canadian-controlled private corporation), this includes a 4% increase to the refundable tax on investment income and a 5% increase to the refundable tax on portfolio dividends.

The changes are technical in nature and of limited value without a detailed review in context. Shareholders of private corporations should discuss these issues with a tax professional, as this could affect dividend/salary decisions and investment policies at the corporate level.

Date for the 2016 Federal Budget?

Parliament last sat on December 11, and it was adjourned until January 25, 2016.

As a final order of business before the adjournment, a motion was brought (and passed) setting forth the membership of the Standing Committee on Finance and authorizing it to commence its pre-budget consultations. The committee’s report will be due back to the House of Commons no later than February 5, 2016.

With the expectation that the government will take time to review the report, we should not expect an announcement of the tabling of the budget until the second week of February at the earliest. The Federal Budget is most often tabled in March, prior to the beginning of the government’s fiscal year on April 1st.