In Canada’s graduated income tax system, knowledge of steadily rising tax brackets is essential, both on the wealth accumulation and eventually the income-drawdown phases.
If you’re still in the first phase and making a high earned income, you have little choice but to pay increasingly higher percentages of income tax on earned income; added to that is investment income. But if you’re in the later phase, or planning for it in the next decade or so, paying attention to tax brackets can save you tens and even hundreds of thousands of dollars.
“Most people misinterpret how our tax system works,” says Doug Dahmer, founder and CEO of Emeritus Financial Strategies. “They fail to understand that taxes are applied on bands of income, where different and increasing rates of tax are applied to each band. Each of these bands is known as a bracket.”
Strategically, the key concept is what Robert Armstrong, BMO’s Vice President, Head of Managed Solutions, terms “topping up to bracket.” Referring to the need to withdraw more than the legal minimum from a Registered Retirement Income Fund (RRIF), Armstrong says people who retire early or phase gradually into retirement by reducing their work hours “will likely be at lower income levels than when they were engaged in full-time work.”
This is especially likely in the years before they qualify for government pensions like Old Age Security or the Canada Pension Plan, or if they are old enough to collect but choose to defer those benefits to perhaps their late 60s.
It’s tempting to enjoy “basking” in those lower tax brackets for a few years but, as Dahmer argues, eventually such taxpayers may eventually be in for a rude shock. Many could find themselves in a tax trap created by forced annual and taxable RRIF withdrawals (from 71 on), which can also leave you exposed to clawbacks of government benefits. “Clawbacks are just another incremental 15% tax bracket,” Dahmer points out.
As Armstrong says, “it may be worthwhile paying a little bit more taxes today to avoid a much higher tax bill and clawback of income-tested benefits in future.”
I always say that if nothing else, in any given tax year I want to maximize the lowest-taxed dollars. Consider that because of the Basic Personal Amount, almost the first $11,474 of income—that’s almost $1,000 a month—is taxed at zero! Compare that to someone in the top tax bracket making over $220,000 a year in Ontario, at which the combined federal/provincial tax rate is 53.53%.
And as my previous Retired Money column highlighted, on top of the Basic Personal Account, many retirees or semi-retirees can expand this “tax-free zone” with the Age Credit (roughly $6,000) and Pension Credit ($2,000 per person). So Dahmer estimates the tax-free zone can work out to $20,000 per person or $40,000 for a couple. Add to that pension income-splitting, which we’ll look at in a future column. But remember, you need to take advantage of these tactics each year as they come up: It’s use it or lose it.
Of course, it’s pretty hard to live on $20,000 a year even if it is tax-free. Aim for much more and soon enough the tax brackets start to kick in at steadily higher percentages. If you think you can get by on $3,000 or $4,000 a month (perhaps that’s your half of the contribution to the family), then you’ll certainly want to “top up” to the 15% federal tax bracket, which (according to TaxTips.ca), applies on the first $41,536 of taxable income. Adding provincial tax and any surtaxes in Ontario, this becomes 20.05% on other income (less on capital gains or dividends).
Depending on the province, there may be as many as 10 brackets. Each time you “top up” to a slightly higher bracket, you’ll pay a bit more on a relative basis for the “extra” income earned. The combined marginal rate in 2016 in Ontario hits 24.15% between $41,536 and $45,282; 29.65% between $45,282 and $73,145, and so on.
Adrian Mastracci, president of Vancouver-based KCM Wealth Management Inc., reminds clients they shouldn’t be driven primarily by tax considerations. However, he suggests most semi-retired Ontarians may at least want to top up to the 24% bracket. “Past that you’re skating into thin ice. The further up you go, the less you save.” So beyond $45,282, “you may want to stop there to see how much more you really need. Going to the first $41,000 is a no-brainer but one day you may need that higher amount to live on.”
Where do you find income to top up? This can be from part-time earned income, self employment, dividends or other passive investment income, triggering non-registered capital gains (and offsetting losses) or taking out some RRSP or RRIF income earlier than required. We’ll look at all of these in future installments of this column.
Jonathan Chevreau writes MoneySense’s Retired Money column, which explores smart ways to draw down income in retirement and semi-retirement. He can be reached at firstname.lastname@example.org.