Most of us have now completed our 2012 tax returns. Have you ever wondered why certain line items on your tax return are tax credits and others are tax deductions? There is a big difference between credits and deductions and how these tax reducers really work.
Since 1986 the tax credit system replaced many line items on your tax return that were formerly tax deductions. This was an attempt by the government to make the tax system fair for all taxpayers. Tax credits reduce tax payable, whereas tax deductions reduce taxable income.
You may be asking, “What’s the difference?” Most tax credits are calculated at the lowest marginal tax bracket. Therefore, as long as your taxable income places you in the lowest marginal tax bracket, there is no difference between tax credits and tax deductions. Tax credits provide the same tax relief for all taxpayers regardless of their taxable income.
Deductions, however, do provide a greater tax benefit to those whose income tax bracket is above the minimum. The more tax deductions you have, the lower your taxable income. One of the more popular tax reduction strategies has been the Registered Retirement Savings Plan, or RRSP. Contributions to your RRSP are considered tax deductible. Every $1,000 you contribute to your RRSP will reduce your taxable income by $1,000.
For the year 2013, taxable income at or below $43,561 will be taxable at the lowest marginal tax bracket in Ontario. That is the point where tax deductions become more advantageous than tax credits. If your taxable income is slightly above this threshold then it may be worthwhile to consider RRSP contributions and reduce your taxable income below $43,561. The same logic applies if your taxable income is above the next level of $87,123. It may be to your advantage to contribute to your RRSP and reduce your taxable income below $87,123.
Most tax credits are non-refundable. This means that once you have reduced your tax payable to zero, you cannot receive any further benefits from your remaining tax credits. There are certain tax credits that are transferrable to your spouse, parent and/or grandparent, depending on the credit and circumstances. Examples would be medical expenses, transit passes, and education credits.
Other tax credits are refundable and generate a refund even when the taxpayer does not owe any tax for the year. This is why it is important to file a tax return even if you don’t owe anything. Refundable tax credits are usually paid throughout the year to assist Canadians with ongoing living expenses. Examples include the HST/GST tax credit.
As we mentioned earlier, most tax credits are calculated at the lowest marginal tax bracket. One exception is charitable donations. Only the first $200 of donations is calculated at the lowest bracket. Donations above $200 receive a benefit at the highest tax bracket. This is designed as an incentive for Canadians to give more to charities.
Tax planning should be done year round, not at the last minute, and certainly not as you prepare your tax return. As you begin your year-long journey toward preparing your 2013 tax return you can consider these ideas to help you make better decisions about tax credits and tax deductions.
The foregoing is for general information purposes and is the opinion of the writer. This information is not intended to provide personal advice including, without limitation, investment, financial, legal, accounting or tax advice. Please call or write to Rick Sutherland CLU, CFP, FDS, R.F.P., to discuss your particular circumstances or suggest a topic for future articles at 613-798-2421 or E-mail email@example.com. Mutual Funds provided through FundEX Investments Inc.