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Our Tax System

Income tax is an integral part of financial planning.  Everyone should have at least a rudimentary understanding of our tax system.

EY, formerly Ernst & Young, an accounting firm, has a great tax calculator and playing with it for 10 minutes is all you need to gain a rudimentary understanding.  You can find the personal tax calculator here.

There are two components to our tax system.  We have rates and tax brackets, and we have accounts with different tax rules.

Rates & Brackets

We live in a progressive tax environment.  The more you earn, the greater the percentage of what you earn is taxed away. Everyone has two tax rates; an average tax rate and a marginal tax rate.  Both are relevant, and your marginal tax rate is higher than your average tax rate.  Your marginal tax rate is the rate paid on the next dollar of income earned.  Your average tax rate is simply income tax paid / total income.

Some sources of income are taxed at different rates.  Capital gains and dividends from Canadian companies both receive preferential tax treatment.  The government wants you to invest for the future and to skew your portfolio towards ownership of Canadian companies.  Business income is taxed at a preferential rate.  The government wants you to open a business and employ people.

Let’s get into the calculator to see how our tax system works.  I am using the 2020 calculator.
Plug $70,000 into the taxable income field and hit calculate.  You see the results for each province.  In Ontario, $13,722 is owed in income tax to the federal and provincial governments combined.  The average tax rate is 19.60% and the marginal tax rate is 29.65%.  The marginal tax rate is the rate on the next dollar of income.  If your boss gives you a $1,000 raise, increasing income from $70,000 to $71,000, your tax bill increases by $296.5.  The raise is worth $703.5 after-tax.  The after-tax value of a $1,000 raise on $20,000 of income is worth $768.  The after-tax value of a $1,000 raise in the top tax bracket in Ontario is worth $465.  More than half the raise is taxed away.  Comparing a raise at different income levels illustrates the progressivity of our tax system.  Here is the most recent calculator.  

You can see federal and provincial combined tax brackets for your province on Canadian Personal Tax Rates.  Here is Ontario for 2019.  All provinces are similar.  Ontarians pay no income tax if income is under $12,068 in 2019.  This is the first tax bracket. They pay 15% on income in the second tax bracket. 25.10% in the third tax bracket.  20.05% in the fourth (it drops, this is not an error) and so on.  This is as of 2019.  Here is the most recent tax brackets for Ontario.  (Brackets are adjusted upward annually to account for inflation.  This eliminates a rising income tax bill due to inflation.  It is a good thing).  Most of all income, whether employment income, rental income, pension income including CPP and OAS, etc. is taxed in this manner.   The taxation when working two or more jobs helps explain our progressive tax regime.

By looking at the tax brackets of your province you notice that dividends from Canadian corporations and capital gains receive preferential tax treatment.  This has consequences.  A dollar’s worth of Canadian dividend income and/or a dollar's worth of capital gain is worth more than a dollar’s worth of interest income after-tax (in a non-registered account).  In Ontario, you pay no tax on dividends from Canadian corporations until taxable income reaches $47,631 in 2019.  Are you listening retirees?  

That is the rate and tax bracket portion of our tax system.  

Accounts play into our tax system.  There are 3 main account types.  The three are the RRSP and all its derivatives.  The derivatives include the RRIF account, any company pension, locked in retirement accounts and the Canadian Pension Plan. There is the TFSA.  And, lastly, the non-registered account, including joint accounts.  The RRSP and the TFSA are designed to incent specific saving behaviour.

RRSP, RRIFS, and their derivatives.  
The government wants us to save for retirement.  The RRSP and all derivative accounts are designed to incent you to save for retirement.  There are two incentives.  The first incentive is that contributions to the account reduce taxable income in the year of contribution and therefore reduce the tax bill.  The flip side is that all withdrawals from the account add to taxable income.  

An example best explains the first incentive.  I am using 2017 rates.  If I earn $75,000 of employment income, or, for example, $65,000 from employment and $10,000 net rental income, my federal and provincial combined income tax bill in Ontario is $15,619 without any unique deductions.  If I make a $5,000 RRSP contribution, I reduce my taxable income to $70,000. Total income tax on $70,000 is $14,136 in Ontario.  My $5,000 RRSP contribution reduced my tax bill by $1,483.  Not bad and this adds up over a career. 

Here is an example of the proper use of an RRSP account.  I work and earn $75,000 and make a $5,000 RRSP contribution.  I reduce my tax bill by $1,483.  The contribution grows within my RRSP without any tax consequences.  I retire and employment income falls to $0.  I receive CPP & OAS and other income that adds to $25,500 and redeem $5,000 from my RRSP.  Total income is $30,500.  My RRSP redemption increases my taxable income by $5,000 and my tax bill by $1,002.  The increased tax bill is $481 less than the tax savings generated years ago when the contribution was made.  This is similar to getting a $1,483 long-term loan from Revenue Canada at the time of the contribution, paying no interest on the loan, and, when it is time to pay back the loan, I only have to pay back $1,002.  This adds up to substantial wealth if done per year over a career.

Many dislike the RRSP account because they have to redeem money at an inopportune time.  Sometimes life gets in the way of plans.  Redemptions add to taxable income.  Let's say I am still working and an emergency arises and I need to redeem $5,000 from my RRSP.  My taxable income increases from $75,000 to $80,000 and my tax bill increases $1,561 due to the RRSP redemption.  I reduced my tax bill by $1,483 with the contribution and increased my tax bill by $1,561 with the redemption.  This is an improper use of the RRSP.

Note that redemptions from an RRSP / RRIF or any other derivative account is taxed as ordinary income regardless of whether the income is dividend income, capital gains, or interest income.

The second incentive is that any activity within the account is a non-taxable event.  There is no immediate tax consequence if I receive dividend or interest income or sell an investment with a capital gain or loss if the proceeds remain in the account.  This incentive becomes clear when contrasted against the non-registered account.

The RRIF account and all its derivatives follow the same tax rules.  RRSP and RRIF withdrawals add to taxable income.
Private pensions operate in the same manner.  Contributing lowers taxable income and receiving payments increases taxable income.

The incentives summarized are an immediate tax reduction when contributing and tax-deferred compounding.

Tax Free Savings Account
The TFSA is simple.  Contributing to the account or redeeming from the account is a non-tax event.  Contributions do not reduce taxable income and redemptions do not add to taxable income.  Everything that happens within the account is a non-taxable event.  This is the benefit of a TFSA.  A main intention of the TFSA account was to provide risk averse seniors a tax break on their GIC income.  They were past the point of contributing to RRSPs but many were still saving and, being risk averse, were saving in fully taxable, interest earning GICs in a non-registered account.  Their after-tax rate of return was lower than their pre-tax rate of return, significantly in many cases depending on their marginal tax rate.  

There are restrictions on how much you can contribute to the TFSA and the RRSP and all its derivatives.  The notice of assessment (the paperwork you get back from the government after you file your tax return) indicates how much contribution room you have for RRSP accounts.  Here is how to obtain TFSA contribution room information.  In both cases unused contribution room accumulates.  Most Canadians have unused contribution room.

The Non-Registered Account  
Every event is potentially taxable.  Receiving interest income is taxable at your marginal tax rate.  Receiving dividend income is taxable either at your marginal tax rate in the case of non-Canadian dividends or at the lower rate for Canadian dividends.    Selling an investment with a capital gain is taxable. Selling anything with a capital gain is taxable.  If I fix up a vintage car and sell it above cost I am supposed to report this and pay tax on the gain.  Only a principle residence is exempt from this.  The rule is 1/2 of the capital gain is added to taxable income.  Capital gains can be offset by selling something with a capital loss.  Note that all income is taxed as ordinary income except for dividends from Canadian companies and capital gains.  These receive preferential tax treatment within a non-registered account.

Some comments
If saving for retirement the RRSP account (and its derivatives) is likely the best path.

If saving for passing on wealth to the next generation the TFSA and a principle residence are better than the RRSP account.  It is probable that a non-registered account is better also.

Passing away with significant assets in an RRSP and all its derivatives including a RRIF is not tax efficient without a surviving spouse.  Explanation is warranted.  When redeeming from an RRSP, RRIF, or any derivative, the proceeds add to taxable income.  Death is deemed a redemption unless you have a surviving spouse.  Let’s say you die on January 1 (you therefore have no other income in the year you die) and you have $200,000 in your RRSP or RRIF.  Due to the deemed redemption, your income will be $200,000 and your final income tax bill will be $70,849 in Ontario.  If you have a surviving spouse the RRSP, RRIF, and any derivative account transfers tax free to your spouse if the spouse is the named beneficiary. The deemed redemption is postponed until the surviving spouse passes away.  

This warrants planning.  Too many seniors pass away with too much in RRIF accounts.  If I have $1,000,000 in my RRSP or RRIF and don’t have a spouse and my doctor guarantees me only 3 years to live, my estate is better off after-tax to redeem $333,333 per year for the next 3 years instead of $1,000,000 in year 3.  Tax on $1,000,000 is $498,662.  Tax on $333,333 is $141,798 per year.  Three years of tax on $333,333 is $425,394.  My estate is better off by $73,268.  


The same logic is true with unrealized capital gains within a non-registered account.  

Many people have soured on RRSPs and derivative accounts for the above and other reasons.  This is wrong headed.  If money was saved in a non-registered account, the account would not have grown to $1,000,000 in the above example.  The ongoing after-tax return would have been less than the pre-tax return.  Years of tax free compounding add up.  There is no tax-free compounding in the non-registered account. 

Further to the above, there is legitimate debate of whether contributing to an RRSP or TFSA is the best course.  (It is likely the RRSP is better than the TFSA. See the Feb 1 2018 Blog entry for analysis)  What isn’t debatable is whether contributing to an RRSP or non-registered account is the best course.  If saving for retirement, the two incentives of the RRSP account vastly overwhelm any potential negatives of saving in an RRSP account.  

Let me clarify a difference between an RRSP and all its derivatives (including RRIFs) and a non-registered account. Anything coming out of an RRSP, RRIF or any derivative account is fully taxable income regardless of whether the income is dividend, interest, or generated from a capital gain.  The type of income is irrelevant.  Contributions to an RRSP or any derivative account reduce taxable income, withdrawals out of an RRSP, RRIF or any derivative account are added to income.  This is a characteristic of the RRSP account and its derivatives.  The type of income matters only with non-registered accounts. Dividends from Canadian corporations and capital gains receive preferential tax treatment only within a non-registered account.

Canadian dividend and capital gain producing investments receive preferential tax treatment compared to foreign dividend and interest earning investments within a non-registered account.

Saving within a TFSA is preferable to saving in a non-registered account for obvious reasons.

Preferred shares pay dividends but have characteristics of safety-like investments.  Preferred shares are underutilized.  Many retirees would be better off after-tax substituting the iShares S&P/TSX Canadian Preferred Share ETF for some fixed income within a non-registered account.  

Note that I can fire my financial planner, financial advisor, bank, or online broker.  If I fire my online broker and move my RRSP to another online broker, I am not redeeming my RRSP and there are no tax consequences to this.  This is a transfer of RRSP assets from one institution to another; not a redemption of RRSP assets.

Another tax benefit of capital gains is you get to decide when to trigger the capital gain and pay the tax.  Tax is not paid until the year the investment with the gain is sold.  It is tax inefficient to trigger substantial gains in one year.  Again, if your doctor  declares with certainty that you will pass away exactly 5 years from now, you would want to trigger some capital gains per year for the next 5 years instead of triggering all in year 5.

Investing in interest earning investments within a non-registered account is tax inefficient.  However, it is better to invest in an interest earning investment and pay the tax and keep the remainder than to not invest and earn 0%.  

Let me say a word on dividends.  I like dividends but not for the reasons typically stated.  A dividend received likely decreases wealth.  Your cash balance grows by the dividend received.  The company’s bank account falls by the dividend paid.  The book value (Assets – Liabilities) of the company is reduced by the dividend paid.  Theoretically your bank balance grows by the exact amount that the value of your ownership in the company falls.  It’s a net wash.  If you receive a dividend in a non-registered account, wealth is decreased by the tax owed on the dividend.

However, there is a human nature benefit to dividends.  We humans tend to think we are better at what we do than we are. Company owners and managers tend to think that they can identify and exploit profitable opportunities more successfully than they can.  This is a positive trait.  There are no self-esteem issues here.  But, it comes with downside.  An unbiased manager would say “we funded projects A, B, & C but can’t find anymore projects that pass a risk / reward test”.   A biased manager would fund projects A, B, C, and less appealing projects D, E, F.  The unbiased manager would return money to shareholders in the form of a dividend.  The biased manager would spend the money.  A project funded that does not pan out is spent money.  More D, E, and F projects fail than A, B, and C projects.

Note that when you receive interest income or dividend income from preferred shares the above is not an issue because you do not have a stake in the value of the company.  All that matters is the company remains solvent.

Other Accounts
The Registered Education Savings Plan – you are incented to save for a child’s post-secondary education.
The Registered Disability Savings Plan – you are incented to save for a disabled person.
The Corporate account – This is a non-registered account with a corporation, not a person, as the owner.  I won’t get into this except to say that there are disincentives to investing within a corporate account.


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