Tax Time: Are You Getting a Big Refund?

It's that time of year again... tax time in Canada. This year every Canadian must file their 2017 taxes and pay any amounts owing by April 30, 2018. That's a little more than two weeks from today.

As most of you know, taxes in Canada are quite complicated. I always do my own tax returns using Genutax. There are other great software programs out there as well: Simpletax, Turbotax, and Studiotax for example. Doing your own taxes is a great way to understand how much tax you are paying and what you can do to reduce that amount as much as possible in the future. Trust me, the nice lady at the mall kiosk doesn't care.

Our tax system is a myriad of credits and deductions at both the federal and provincial levels. Child care, RRSP contributions, medical expenses, education, charitable contributions, union dues, interest costs, pension adjustments, kids fitness, arts, and whatever your government decides is good for you at that moment in time.

After you plunk all those numbers in your tax return, you find out if you get a refund from the government or if you owe them more money than what you already paid. What is the best outcome?

Getting a Nice Refund

Most people are very happy when they get a refund cheque sometime in April or May. However nice this little bonus might seem, it is NOT the ideal outcome. Do not confuse a refund with some form of extra income. Extra income is something like the Canada Child Benefit or Old Age Security--money from the government that is not really paid by you but which you receive on a regular basis because you meet certain criteria. A refund is getting your money back because you paid too much to begin with.

Put it this way... you go to the store and buy a pair of pants that cost $100 but was marked 20% off. The clerk made an error that you didn't immediately notice and charged you $100 plus tax. You paid full amount, stuffed the pants into your backpack, hopped on your bike and were halfway home when the thought crossed your mind that you paid too much. You check your receipt and sure enough the discount wasn't calculated, so you bike back to the store and get your $20 back.

Did you earn back that $20 from the store? Absolutely not! You made the purchase expecting the discount amount so you are simply getting a refund because the store collected to much money from you in the first place. It's actually inconvenient because you wasted your time, effort, and dignity by going back to the store and grubbing for that $20 you never should have paid in the first place. This simple mistake makes you obliged to the store rather than the store being grateful for your business.

Tax refunds work the same way. Your employer follows some standardized criteria to deduct money for taxes from each paycheque all year long. It's not tailored to your personal situation and is actually designed to make sure you pay more than you need to.

By giving the illusion of having the government owe you rather than you owing the government, you are now at their beck and call. You will file your tax return on time, you will appreciate anything they give you back, and if they dispute something you've done on your return, they hold back money which is rightfully yours until you prove yourself innocent.

The government wants to give you a refund because it's insurance. Also, it ensures they get paid first and it gives them an interest free loan that grows all year. If five million Canadians get an average refund of $500 every April, that's an accumulated free loan of $2.5B every year.

If you get a tax refund every year, especially a big one, you are doing something wrong. You should first ask your employer for a TD1 form. This form allows you to direct your employee to adjust your tax deductions lower for things like the age amount, caregiver amounts, education amounts, and disability amounts.

Next you need to look at the T1213 Form. The T1213 must be sent to the CRA after you complete because they must provide approval before your employer can reduce tax deductions. The T1213 allows you to deduct things like RRSP contributions, child care expenses, family support payments, investment loan interest expenses, and many other items.

By completing a TD1 and T1213 accurately, you should be able to drastically reduce the amount of your tax deductions each paycheque and the size of the tax refund every April. The only downside is this must be done every year, however the pay-off is worth the postage stamp.

Pay a Little More Tax

This might sound a little counter-intuitive, but if you are doing your tax preparation correctly every year you should actually be paying the CRA a small amount after your tax returns are done each April. I'm not talking thousands of dollars that you can only pay with a line of credit because you don't have the cash on hand, but a moderate amount that you can afford is perfectly fine.

While your co-workers brag about the size of their refund, calmly cut the government a cheque and understand you are better off for it. Not unlike using a credit card to collect points or cash back, it's alright to be in debt to the government as long as you pay them back when you are supposed to.

Enjoy filing your taxes in the next few weeks and if you are getting a refund, check out the TD1 and T1213 to make sure it doesn't happen again! Of course, if your refund is due to RRSP contributions make sure you put that money into your investment account because you will owe taxes on RRSP withdrawals down the road. If your refund is not because of RRSP contributions, still invest it and put that money to work for your future self!

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Reduce Taxes on RRSP Withdrawals in Retirement

RRSPs are a fantastic vehicle for retirement savings and reducing your lifetime tax bill. I compare RRSPs to TFSA and Non-registered Accounts in this post. While RRSPs with re-investment of the tax refund are the best way to save for retirement broadly speaking, there are many caveats. Those caveats often make it easier, for newer investors in particular, to invest in a TFSA instead for simplicity's sake. TFSAs perform well from a tax-perspective, are very flexible accounts, and provide ease of tax management across all income levels.

However, the RRSP really shines if you earn an above average income and keep your spending levels low. Only RRSPs can provide really large tax arbitrage opportunities, especially if you can employ some tricks to keep your tax rate very low on RRSP withdrawals. You always want to contribute to RRSPs at high tax rates and withdraw at low tax rates.

While there are some withdrawal programs specific to RRSPs, such as the Lifelong Learning Plan for full-time adult education and the Home Buyers' Plan for new home buyers, this post will discuss tax issues on standard withdrawals. That said, if you are considering going back to university as an adult, or are buying a house, do not ignore the LLP and HBP because they do provide tax advantages in their own way.

1. Using the Basic Personal Deduction

All of the provinces and the federal government have a basic personal amount which you can deduct from your income. Essentially any amount of money you earn below this deduction amount is tax free.

The federal basic personal deduction is $11,809 (in 2018). The provinces range from a low of $8,160 in P.E.I. to a high of $18,915 in Alberta.

This means you can withdraw at least $8,160 from your RRSP and pay no taxes anywhere in Canada, provided you realize no other taxable income. That range for a couple by province is from $16,320 to $23,618.

Of course, this is a small withdrawal amount and your income will likely need to be increased with eligible dividends, TFSA withdrawals, spending cash savings, or selling investments which have no capital gains.

2. Split Your RRSP Income

If you want to increase your ability to withdraw money from your RRSP, get married and stay married. Splitting RRSP income with your spouse allows you to benefit from two sets of tax credits instead of one.

You can set up RRSP splitting in two ways. In the first method you contribute completely to your standard RRSP. Then, at age 65 or older, you can convert at least a portion of your RRSP to a RRIF. This way withdrawals can be eligible for the Pension Tax Credit. Income that is eligible for this credit can be split up to 50% with your spouse. Not only will you be able to take advantage of two basic personal deductions and other credits, you can further benefit from the Pension Tax Credit to increase your overall withdrawal amount at zero tax rates.

The second method requires more planning. Any contributor can set up both a personal RRSP account and a spousal RRSP account. Contributions to either RRSP are deducted from the contributors "RRSP room". However, the personal RRSP benefits the contributor while the spousal RRSP benefits the spouse of the contributor.

If I earn $100,000 per year and my RRSP contribution limit increases by $18,000 per year, I can contribute $9,000 to my personal RRSP account and $9,000 to my spousal RRSP account. My spousal RRSP contributions will in no way impact my spouse's personal "RRSP room". In retirement, the spousal RRSP withdrawals go completely to my spouse. Provided both accounts are invested the same way, the account values and withdrawals will be equally attributed to each partner in retirement.

3. Offsetting with Eligible Dividend Income

If you use your non-registered investment account to invest in Canadian-listed corporations which pay dividends, those dividends can be taxed at negative income tax rates in many provinces. The rate of negative tax depends on your income level and your province of residence.

B.C. is the best province for this strategy as it has the highest negative tax rates on income under the first federal tax bracket ($46,605 in 2018). Alberta, Ontario, and Saskatchewan also have negative taxes on eligible dividends, but at lower effective rates.

In this strategy, you can use dividend income to offset some of the income taxes owing on RRSP withdrawals. This strategy will often allow an individual to withdraw a few thousand dollars more from their RRSP tax-free above the basic personal amount for their province.

However, the amount of RRSP income you can realize this way is still quite limited. Also, you might need to top up any other spending needs with TFSA withdrawals, cash savings, or selling positions in your non-registered accounts that have no capital gains.

4. Offsetting with Interest & Carrying Costs

The best way to significantly reduce taxes on your RRSP withdrawals is to reduce your taxable income with eligible interest expenses. If you borrow money and use that money to purchase investments (not in registered accounts), you may completely deduct the interest expenses associated with that loan from your total income. That's right, if you earn $40,000 in fully taxable income and you have $40,000 in interest expenses, your net taxable income becomes zero!

There is a small caveat however. The investments purchased with the loan money must generate some form of income that's acceptable to the CRA. This includes dividends, interest, foreign dividends, business income, or rental income. The income amount is not required to exceed the interest cost. It's important to note that investments which exclusively distribute capital gains or Return of Capital do not meet the CRA's definition of income for this purpose.

There is really no limit to how much interest costs you can expense, but of course it's smart to try borrow at low rates, manage your debt as a percentage of equity, and to buy investments which are tax efficient. You always want to ensure your loan is used to buy investments which are profitable and fit your risk profile.

A HELOC loan on a paid off house is a great choice for a low interest investment loan. With a HELOC you can borrow up to 65% of the value of your house for Prime + 0.5% interest. Margin loans with Interactive Brokers, National Bank Direct, or RBC Direct (Royal Circle only) are also good options.

The most ideal investment from a tax perspective might be Canadian stocks which pay low yielding eligible dividend income. Some examples of companies which fit this profile are Alimentation Couche-Tard (trades as ATD-B.TO), CP Rail (trades as CP.TO), Brookfield Asset Management (trades as BAM-A.TO), Stantec (trades as STN.TO), Fairfax Financial (trades as FFH.TO), Imperial Oil (trades as IMO.TO), or Waste Connections (trades as WCN.TO) to name a few.

The key is to borrow at a reasonably low rate (under 4% at today's rate environment) and purchase stocks with a dividend yield under 2%. If you buy foreign assets, target a yield under 1% as foreign dividends at fully taxed.

For example, let's say you own a paid-off home worth $700,000 in B.C. You can borrow $455,000 with a HELOC at 3.95%, translating to an interest expense of $17,972 per year. If you invest that money in Canadian companies with an average yield of 1%, you could withdraw up to $30,000 from your RRSP completely tax free as a single taxpayer. The RRSP withdrawal amount would be even higher as a couple since you could split the interest expenses and dividend income.

5. Income Tax Targeting

I personally believe the best way to tax plan in retirement is by taking a complete, realistic portfolio approach. This means not focusing on any one account, one form of income, or complete minimization of taxes. Instead, target an acceptable tax rate based on your spending needs and formulate a plan around that.

For a moderate spending couple with investment assets an acceptable total retirement tax rate might be 10% if you are located in a lower tax province. RRSP contributions save you tax at your highest marginal tax rates--often well into the 30% range and sometimes even over 50%. At these refund rates, the tax benefit for using RRSPs would be substantial for most people, even when paying 10% tax on withdrawals.

We know that RRSPs (with tax refund re-investment) and TFSAs theoretically perform equally well from a pure income tax perspective when you contribute and withdraw money from the accounts at the same marginal tax rate. In a scenario of equal tax rates, the TFSA would win because of the flexibility the account offers and it doesn't expose you to clawbacks on benefits.

However, if you can gain a tax spread of 20%+ on your RRSP withdrawals relative to contributions, you are doing really well from a tax perspective. It's this spread that makes the RRSP an ultimate savings account for smart investors.

To execute a tax targeting plan, you would first start with the investment income types which are less easily controlled. This might include dividends, foreign dividends, and interest income. Then you would top off your taxable income with RRSP withdrawals or by realizing capital gains to increase your adjusted cost base. You would trigger just enough income to hit your target blended income tax rate.

It may be worthwhile to realize income at a low tax rate, even if you don't need the money for spending reasons. You can always re-invest the unused income in your TFSA accounts or your non-registered accounts. This can help reduce tax rates in the future and allow for more flexibility in spending. Remember, if you are able to shrink your taxable income down to very low levels when you are 65 or older, you can get some great social benefits.

On the other hand, if you have a year in which you are planning to spend a significant amount of money relative to your usual spending, you may also use tax targeting for that. You could withdraw the money from your TFSA or by realizing capital gains to pay for renovations, vacations, or other similar one-time expenses. Since TFSA withdrawals can be re-contributed in future tax years, the penalty for a short-term withdrawal is not that significant.

Comments & Questions

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