Effective Tax Planning for Individuals

Canadian personal tax system is progressive, i.e. the higher your income, the higher is the applicable tax rate. Effective tax planning involves managing your affairs in such a way that it decreases the overall tax liability by reducing your taxable income.

Tax planning for individuals requires a certain level of groundwork. To begin with, this involves identifying the tax bracket that applies to you, so that if your income were to increase, the marginal tax rate on the additional income can be worked out. It also requires understanding which of your income-generating assets are taxable and which ones are not. If you have a spouse, there may be opportunities for income splitting. There are also tax credits available for charitable donations, medical expenses, disability and dependants living with you, just to name a few.

Following are some tax planning tools available to individuals.

1. Contribute into a Registered Retirement Savings Plan (RRSP)

Putting money into RRSP gets you a deduction from the total income that lowers the amount of tax payable for the year. Income received within RRSP remains tax-free, but tax is applied when you withdraw funds from RRSP. Essentially, RRSP is a retirement savings vehicle since it allows you to defer taxes on contributions into RRSP and on your earnings until retirement, at which time you pay tax based on the applicable marginal rate. Most people are usually in a lower tax bracket after retirement; hence, the tax rate is likely to be lower than what it would be now. You can also use spousal RRSP for tax planning when the spouses are in different tax brackets.

2. Invest into a Tax-Free Savings Account (TFSA)

TFSA provides a tax-free option to earn investment income, such as interest, dividends, and capital gains. Money deposited into a TFSA can grow on a tax-free basis, and no tax is payable when you withdraw that money or your earnings. TFSA provides an effective tax planning tool for low- and modest-income earners since they can earn investment income within TFSA without reducing or becoming disqualified for government benefits and credits that are linked to their income level. Another way TFSA can be used in tax planning for individuals is for a high-income spouse to gift money to a low-income spouse to contribute into the spouse’s TFSA or for a parent to gift money to a child who is at least 18 years old for contributing into the kid’s TFSA.

3. Give Charitable Donations

Giving is a joy in itself! You can double the joy by claiming charitable donation tax credit to reduce your tax liability. The federal tax credit is 15% on the first $200 of donations to registered charities and then at a much generous level of 29% on additional donations in a year. The tax credit can reach 33% if you are in the highest tax bracket. In tax planning for individuals, unused charitable donations may be carried forward for up to five years so that the tax credit can be claimed in a later year when taxable income is higher than usual. You can also share charitable donations with your spouse to enable the higher-income spouse to reduce the tax bill.

4. Income Splitting

Splitting income with the low-income spouse can reduce taxable income and marginal tax rate of the high-income spouse. Income splitting needs to be approached with caution to ensure that tax reduction arrangements are not subject to tax on split income (TOSI) rules, attribution rules or otherwise inconsistent with the intent of law. Despite the scrutiny, certain income splitting opportunities remain available for the benefit of taxpayers. These include the spousal RRSP and TFSA arrangements noted above as well as the opportunity to transfer dividend income to a spouse, lending money to spouse for investment, and pension income splitting. Each arrangement comes with its set of rules and caveats that must be considered for effective tax planning.

Choose Wisely

The above-mentioned ways are just a few of the many different techniques one can use for effective tax planning. Tax planning cannot follow a ‘one size fit all approach’. You need to be careful in deciding which tax planning strategy works best for you and choose the optimal combination that can help reduce taxes. Depending on your circumstances, it may be useful to obtain professional advice for tax planning that caters to your specific situation.