Investing for Canadians 101 — Part 2- Canada’s Tax System
So in part 1 we talked about why you should invest and basic finance concepts. In this part we will cover the basics of Canada’s tax system from an investing perspective.
Canada’s Tax System
Before we get into the details let’s hit a few important points:
- The information presented here may change at any time however this is the current state as of Jan 20th 2016. For more information on Canada’s taxes and all taxes please consult Canada Revenue Assurance Agency (CRA) website.
- There are many types of taxes that you will have to pay and deal with during your lifetime in Canada. I am definitely not intending to cover them all in this guide but I will be covering the ones that are relevant to saving and investing.
- The tax calculations are slightly cumbersome so I won’t get into lots of details except what is relevant for you to understand as an investor. So I will define and highlight some basic concepts first and then try to put it all together in an example.
- I recommend you use a good professional accountant or tax software such as Turbo Tax to file your taxes. You can do it yourself but a good accountant generally know what to look for and how to help you get the maximum deductions. Also an accountant will cost you 40–80 dollars per year to file your PERSONAL TAXES so its not expensive and totally worth it.
- CRA has a good course to help you learn about taxes. I recommend you check it out.
In Canada whenever you earn income you will have to pay taxes on it. Taxes are paid at both the Federal Level (Government of Canada), and Provincial (Government of the province you are living in; Ontario for example). Every year you have to file with the CRA and declare all of your income and pay any taxes that you owe (well unless you want to go to jail).
- The taxes you pay are based on your total income, and the more you make the more you pay.
- Provincial and Federal taxes are set in brackets / levels. The higher you earn the higher the bracket is and hence the higher you pay.
- For example for 2016 the federal tax brackets are as follows
- 15% on the first $45,282 of taxable income, +
- 20.5% on the next $45,281 of taxable income (on the portion of taxable income over $45,282 up to $90,563), +
- 26% on the next $49,825 of taxable income (on the portion of taxable income over $90,563 up to $140,388), +
- 29% on the next $59,612 of taxable income (on the portion of taxable income over $140,388 up to $200,000), +
- 33% of taxable income over $200,000.
- CRA sets and changes tax rates and brackets from year to year. See the current tax rates here.
- You can reduce your taxable income by taking advantage of CRA’s tax deductions and tax credits (see below)
Taxable sources of income
There are many types of income that are taxed including :
- Employment income (AKA your salary)
- Dividends (In case you don’t know what Dividends are check the definition. What you need to know now is that if your stocks pay dividends you will have to pay taxes on these dividends)
- Interest (AKA interest you earn on money when you put it in a regular savings account)
- Taxable capital gains (if you can’t sleep and need something to put you to sleep you can read this CRA document on Capital gains and losses, otherwise know that if you sell an asset such as a stock, bond, house, gold, and you make money, the profit you make is taxed. We will talk about this in more details later)
Non taxable sources of income
There are a few types of income which are not taxed such as income you earn from some lucky events (you are given gifts, or earn the lottery) or unlucky events (collecting inheritance or life insurance policy). Check CRA website for sources income that are not taxed.
Tax deductions and tax credits
Tax deduction: Tax deductions reduce your taxable income therefore reducing your the amount of taxes you pay. RRSP (we will talk about later) and child care expenses for example are deductions. So are capital losses.
Tax credits: Tax credits reduce the amount of taxes you owe directly and do not affect your net income. There are two types of Tax Credits :
- Non-refundable tax credits: You get these credits only if you owe taxes, and to the maximum of the amount you owe. For example if you owe 0 in taxes and you have 200 non-refundable tax credits the government does NOT pay you 200. They pay you nothing. If you owe 200 in taxes and have 200 in non-refundable tax credits you pay 0, etc. Examples of such tax credits are basic personal amount, medical expenses and charitable donations.
- Refundable tax credits: You get these credits regardless of whether you owe taxes or not. Examples of these are Child Tax Benefit, GST/HST credits, Working Income Tax Benefit.
You can learn more about deductions and credits on CRA website here.
If you read the above section then you have realized by now that in every move you make, and every step you take, they will be taxing you … Sorry could not resist plugging in this song …
But wait … There is some hope…
CRA Registered Accounts / Saving plans
So CRA is nice enough and generous enough to allow you to set aside some money, tax free, for your retirement and for other purposes, but of course, as with everything in life, there is a catch.
As the name implies a registered account is an account that your financial organization (bank) registers with the federal government (Government of Canada) so that whenever you open the account or make various transaction the government generally gets notified. This is normally done because there are tax implications to depositing, withdrawing, and making various transactions under that account.
Types of registered account include RRSP, TFSA, RRIF, and a few others which are NOT interesting for us at this point in time and not relevant to this conversation.
Registered Retirement Savings Plan account (RRSP):
An RRSP account is an account that allows you to save for retirement.
- Note that this is NOT a bank account such as one you can deposit or withdraw money from.
- RRSP is called an Umbrella account which means you can hold various sub-accounts under it. Think of it as a placeholder.
- For example under the RRSP umbrella you can have a savings account and you can also hold other financial assets such as Stocks, Bonds, Mutual Funds, and Guaranteed Investment Certificates (GICs). (We will discuss these assets in depth in the coming post)
- RRSP is called a Tax-Deferred type of account. This means you contribute to your RRSP from your PRE-TAX income (which reduces your taxable income), and your growth and the money in the account is not taxed until you withdraw this money when you retire. Taxes are differed then until you withdraw money from the account.
- If you withdraw money from an RRSP before retirement you will be hit with penalties and taxes unless you are buying a house for the first time for your primary residence then there is a special program for that.
- RRSP savings have a ceiling. You cannot contribute or hold as much money as you want in an RRSP. The limit under which you can contribute money to an RRSP depends on your previous year’s earned income. The limit for this year’s contribution is a percentage of your last year’s earned income. If you try to save or contribute more than your limit then you will be hit with penalties and taxes as well. This is often referred to as your RRSP contribution room.
- If you have contributed to your RRSP but did not hit the limit, the remaining amount is carried forward to next year and is added to that year’s contribution limit.
- Usually by the time you are ready to retire you need to convert your RRSP into another account (RRIF) and your money will be withdrawn (and taxed) through the RRIF. So you pay taxes on the money when you withdraw it.
How RRSP works
The whole premise of RRSP is that usually on retirement you earn no additional income, and your only income will be your withdrawals from your RRSP/RRIF.
- If you are working today say you are earning 80k then you are being taxed on 80k
- If you are working today earning 80k and contribute to RRSP 10k, you are being taxed on 70k.
- When u retire, you do not work at all, say you withdraw 40k/year from your RRIF, you are taxed on 40k/year (I assumed 40k for simplicity).
- Let’s try to apply CRA federal taxes brackets on your 80k here to see how this works:
- On the first 45,282 you pay 15% taxes
- On the next 34,718 (80,000–45,282) you pay 20.5% in taxes.
- If you save 10k in your RRSP and your income is now 70k
- On the first 45,282 you pay 15% taxes
- On the next 24,718 (70,000–45,282) you pay 20.5% in taxes.
- Notice that the 10k we took out should have been taxed at 20.5% but now it is out of the equation.
- For simplification let’s assume your salary continues to be 80k every year and you save 10k and the taxes brackets remain the same, and you retire in 4 years.
- By the time you retire you will have 40k in your account + whatever growth these 40k made.
- Assuming you take out 40k from your RRIF per year then you will be taxed at 40k tax rate.
- Applying brackets it means your tax bracket is the 15% tax bracket therefore you only pay 15% in taxes.
- This means your 10k’s (4x10k each year ) which would have been taxed at 20.5% years ago (before you retire) are taxed now (when you retire) at 15% tax rate. Plus take into account all the tax free growth.
- Notice that this example above just shows federal taxes, there are also provincial taxes which apply the same way but I omitted that calculation because it is the same.
Tax Free Savings Account (TFSA)
- TFSA is an account that allows you to save money tax — free; your growth and dividends are not taxed.
- Just like RRSP , TFSA is NOT a real account such as one you can deposit or withdraw money from.
- Just like RRSP, TFSA is also an Umbrella account which means you can hold various sub-accounts under it.
- For example under the TFSA umbrella you can have a savings account and you can also hold other financial assets such as Stocks, Bonds, Mutual Funds, and Guaranteed Investment Certificates (GICs). (We will discuss these assets in depth in the coming post)
- TFSA is called a Tax- Sheltered type of account. This means you contribute to your TFSA from your POST-TAX income (net income) (as a result TFSA contributions do not impact your income or your taxes), and your growth and the money in the account is not taxed at all.
- You can withdraw money from the TFSA at any time. That money will not be taxed. This makes TFSA ideal for an Emergency savings account.
- TFSA savings has a ceiling (contribution room). You cannot contribute or hold as much money as you want in a TFSA.
- TFSA contribution room is a little bit different than RRSP. You can read more about it here. But the basic idea is this; TFSA started in 2009 and the limit for years 2009 up to 2012 is $5000 / year. So if you are a Canadian above the age of 18 by 2009 every year you are allowed to contribute 5000, etc.. For 2013 and 2014 contribution room is $5500. 2015 is 10,000 thanks to the old government, and now its back to 5500 thanks to the new government for 2016.
- If you are not a Canadian resident and you became one only this year then your contribution room starts from next year and you only have this year’s contribution room which is 10,000.
- When you file your tax income with CRA for a year, they will let you know what your contribution room for TFSA will be for the next year, similar to RRSP.
- If you over-contribute to TFSA you will be hit with penalties.
- If you have contributed to your TFSA but did not hit the limit, the remaining amount is carried forward to next year and is added to that year’s contribution limit.
- The whole premise of TFSA is that you contribute from your taxed income and your growth /dividends are tax free.
Let’s take a concrete example because I know this can get super confusing:
Let’s take an example of an immigrant who came to Canada in 2015: You land in Canada in 2015, at this point you CANNOT open a TFSA account as you have not filed your taxes. At end of 2015 you file your tax return. Your TFSA does not impact your salary or taxes, hence we won’t discuss them.
According to CRA’s rules your TFSA contribution limit for 2015 is 10,000. This is the amount you can contribute in 2016 + the 2016 amount which is 5500.
This means in 2016 you can contribute 15,500 maximum. Now in 2016 you save only 5,500 in your TFSA so you carry forward a 10k for 2017. For simplicity let’s assume that TFSA contribution room rules set by CRA remain the same, therefore your contribution room for 2017 is 5500.
This means that your contribution room for 2017 is actually 15,500 now.
This concludes our Tax system discussion. In the next part we will talk about investment options, explain stocks, bonds, mutual funds, etc.. then we will bring it all together with a concrete investment and financial strategy. I’m sorry about all this theory but I think not everyone has these basic concepts especially if you are an immigrant who is new to the country.