Effective tax planning can have a different meaning and emphasis depending upon your personal circumstances. As Albert Einstein said, “The hardest thing in the world to understand is income tax.”
Sometimes tax planning brings immediate benefits, but often the benefits of tax planning take time to be realized. Many people are scrambling to get their taxes done for the current year, so it is too late to do any planning for the previous year.
The key building blocks of effective planning are:
- Maintain good records;
- Keep informed and up to date;
- Know your needs and your goals;
- Assemble a team of good professional advisors.
The Three Ds of Effective Tax Planning
The three Ds to effective tax planning are Deduct, Defer, and Divide. You must understand each of these important functions to plan effectively.
A deduction is a claim to reduce your taxable income. A deduction will reduce your tax bill by an amount equal to your marginal tax rate. Some common deductions include:
- Pension plan contributions
- Union/professional dues
- Employment expenses
- Moving expenses
- Professional fees
- Child care expenses
- Alimony/maintenance payment
A deferral strategy attempts to delay when tax will be paid. Deferring tax means you might eliminate the tax this year, but you will have to pay eventually. Generally tax deferral has two advantages: It is better to pay a dollar of tax tomorrow than it is to pay a dollar of tax today; and tax deferral typically puts the control of when to pay the tax in the hands of the taxpayer instead of in the hands of the Canada Revenue Agency (CRA).
RRSPs, RESPs, Life Insurance Contracts, and various investment income strategies are the most common forms of tax deferral for the average Canadian
Dividing taxes (or income splitting) implies taking an income and spreading it among numerous taxpayers. For example, it is better to have two people (say a husband and wife) pay tax on incomes of $35,000 each than one person pay tax on an income of $70,000. Unfortunately, you cannot arbitrarily decide who is going to claim what amounts for income.
There are, however, strategies to divide income within the rules of the CRA:
- Contribute to a spousal RRSP to help split income in retirement;
- Split CPP retirement benefits and qualified pension income with your spouse;
- Invest non-RRSP savings in the lower income family members;
- Invest the child tax benefit in your children’s name;
- Contribute to a registered education fund;
- Pay wages to family members (through a business);
- Use partnerships or corporations to earn business income;
- Use either inter-vivo or testamentary trusts.
Please refer to our RRSPs section for information on associated tax laws.