Key takeaways:
- How income is taxed in Canada.
- The difference between tax credits and tax deductions.
- Using registered investment accounts to reduce income tax.
- How to maximize tax deductions and credits.
- Making tax-efficient investment decisions.
Effective Canadian tax planning is about more than just getting a refund; it’s about creating a long-term approach to protecting your wealth and keeping more of your income.
To lower your income tax in Canada, you need to know the difference between what you pay taxes on, what deductions you can use and what credits are available to you. Adopting strategic tax practices year-round — rather than only at filing time — can significantly enhance your financial well-being.
Understanding taxable income in Canada
Before exploring practical steps, you need to understand how the Canada Revenue Agency (CRA) defines "taxable income". Simply put, taxable income is your total earnings from all sources — including employment, self-employment, interest, dividends and capital gains — after subtracting eligible deductions.
Canada’s progressive tax system means your tax rate rises as your taxable income increases, bumping you into higher tax brackets. By reducing your taxable income, you could possibly move to a lower tax bracket and/or have a lower marginal tax rate (the amount of tax you pay on your next dollar of income). This would directly reduce your total tax payment to both the federal and provincial governments.
Distinguishing between tax credits and tax deductions
Taxpayers often get confused between deductions and credits. Both can help you save, but they work differently in your tax return.
What are tax deductions? Tax deductions lower your total income before calculating tax. Their value matches your marginal tax rate. For instance, if your marginal tax rate is 40%, a $1,000 deduction could save you as much as $400 in taxes.
What are tax credits? Credits come into play after your tax has been determined, reducing the amount you owe. Most credits are "non-refundable", meaning they can lower your tax bill to zero, but you won’t get extra money back. Credits are usually applied at the lowest rate, regardless of your income.
Let’s take a look at five key strategies to reduce income tax in Canada.
1. Lower your taxable income with RRSP and FHSA contributions
Contributing to a Registered Retirement Savings Plan (RRSP) is one of the most effective ways to reduce income tax in Canada. RRSP contributions are fully deductible, meaning that every dollar you contribute will reduce your taxable income by a dollar. This strategy is particularly beneficial if you’re currently in a high tax bracket and expect to be in a lower bracket when you withdraw funds once you retire.
The First Home Savings Account (FHSA) is an excellent tax-saving option for first-time homebuyers. Like an RRSP, FHSA contributions reduce your taxable income dollar for dollar. Unlike RRSPs, withdrawals used to buy your first home are entirely tax-free. Using both the RRSP and FHSA can provide you with significant upfront tax savings and help you build your wealth (and get you into your first home) faster.
2. Maximize TFSA and RESP contributions
Canadian tax planning usually involves making contributions to a Tax-Free Savings Account (TFSA) or Registered Education Savings Plan (RESP). While contributions aren’t tax deductible, they still provide considerable tax savings.
With a TFSA, all investment growth (including interest, dividends and capital gains) is tax-free, and withdrawals do not count as taxable income. This shelter from ongoing taxes helps you keep more of your investment income.
If you have children, an RESP can help build their education fund. Although you can’t deduct contributions, the government’s Canada Education Savings Grant (CESG) matches 20% of your first $2,500 contribution each year (up to a lifetime maximum of $7,200 in CESG). Investment growth is also tax-free, until your child makes withdrawals, at which point they’re likely to be in a very low tax bracket.
3. Claim all applicable deductions, credits and government benefits that apply to you
Many taxpayers miss out on valuable credits and deductions that, when combined, can considerably reduce income tax in Canada. Frequently missed deductions and credits include:
- Medical expenses: if eligible medical costs exceed a set percentage of your income, you can claim a credit.
- Charitable donations: federal and provincial tax credits for donations increase substantially for total gifts above $200. You can combine donations with those of your spouse to maximize the overall tax credit.
- Child care expenses: these include daycare and overnight/summer camps.
- The Disability Tax Credit: a non-refundable credit for individuals with disabilities or family members who support them.
Claiming every available benefit, such as the Canada Child Benefit (CCB) or GST/HST credit, can also help grow your wealth faster.
4. Make tax-wise investment choices
As we’ve seen, it makes sense to hold your investments in registered accounts (such as RRSPs, FHSAs, TFSAs and RESPs). However, if you max out these accounts and need to place some investments in non-registered accounts, any income from these assets will be classed as taxable income.
It’s important to know, therefore, which investments to place in your non-registered accounts, given that some investment income gets favourable tax treatment from the CRA. These investments should also align with your risk tolerance level.
Interest income from GICs or bonds is taxed at your full marginal rate, making it the least tax-efficient. It’s wise to hold these investments inside registered accounts.
Capital gains, which occur when you sell investments (such as stocks and mutual funds) at a profit, are only partially taxable (currently 50%). Eligible Canadian dividend payments also get preferred tax treatment. It makes sense therefore to hold assets that are likely to make capital gains and earn dividends in non-registered accounts.
It’s also crucial to cash in investments needed to provide retirement income in a tax-efficient way. By diversifying your retirement income sources (for example, by including withdrawals from TFSAs and tax-free returns of capital from non-registered accounts) you can considerably reduce your taxable income and therefore your tax bill.
5. Maximize available deductions if you’re self-employed
If you’re self-employed, you have greater options for reducing your taxable income, including deducting reasonable expenses incurred to earn business income. These deductions include a share of home office costs (utilities, internet, insurance, etc.), vehicle expenses for business use, professional fees and equipment purchases.
Careful tracking of every eligible expense could greatly lower your taxable business income and therefore your tax bill.
Your IG Advisor can help you keep more of what you earn
Now you’ve learned how to reduce income tax in Canada, the next step is to minimize it as much as possible. Canadian tax rules are complex, and everyone’s finances are different, so getting expert Canadian tax planning advice could save you thousands.
Speak with your IG Advisor for personalized guidance to help minimize your income taxes. With their knowledge of your full financial picture, they could uncover tax-saving opportunities that your accountant might miss. Talk to your IG Advisor today to discuss ways to reduce your income tax. If you don’t have an IG Advisor, you can find one here.
Written and published by IG Wealth Management as a general source of information only. Not intended as a solicitation to buy or sell specific investments, or to provide tax, legal or investment advice. Seek advice on your specific circumstances from an IG Advisor.
Trademarks, including IG Wealth Management and IG Private Wealth Management, are owned by IGM Financial Inc. and licensed to subsidiary corporations.
The Canada Education Savings Grant and Canada Learning Bond (CLB) are provided by the Government of Canada. CLB eligibility depends on family income levels. Some provinces make education savings grants available to their residents.
