Tax Deferral

Tax deferral is a common tool used in tax planning. It refers to delaying paying tax into the future.  Instead of paying the tax now, but paying the tax in the future, you can hold onto your money now, invest it and allow it to grow.  Plus, you can pay the tax debt in the future with money which is worth less than today. As discussed earlier, due to inflation a $100 bill in the future is worth less (and has less buying power) than $100 now.  So, if one has a tax debt of $100 – it is better to pay it with $100 future dollars rather than $100 today dollars.  In other words, it is better to defer the payment of the tax until the future.  And if you can hold onto the $100 for a while and invest it until you have to pay it to the CRA, that is even better.


With investment vehicles such as the Registered Education Savings Plan (RESP) and the Registered Retirement Savings Plan (RRSP), rather than paying tax now with today dollars, taxpayers can choose to pay tax on income in the future at a time when they are subject to a lower marginal tax rate.


The RESP and RRSP are the most common vehicles for the average Canadian to benefit from tax deferral. With an RESP, a subscriber contributes income and in turn interest, dividends, and capital gains are earned within the RESP. When the money is finally withdrawn, it is taxed at the low marginal tax rate of a student enrolled in an eligible higher education program such as a university, college or trade school. An added benefit of an RESP is that the Canadian Government will include up to $7,200 as a no-strings-attached grant in an RESP. Up to $500 a year can be received as a grant depending on what the subscriber contributes into the account annually.


An RRSP is another popular vehicle for Canadians to benefit from tax deferral. With an RRSP, taxpayers can deduct the amount that they invest from their tax returns. This means that no income tax is paid on the amounts invested.  In turn, the investment can grow tax deferred inside the RRSP. Similar to an RESP and a Tax-Free Savings Account, there are massive financial benefits to tax sheltered compounding. Although tax is paid upon withdrawal from an RRSP, the taxpayer has control over when it is withdrawn. If a taxpayer retires at 65, and only has pension income (which places them in a lower marginal tax bracket than where they were pre-retirement), then they could save anywhere from 4-30% on each dollar withdrawn from the RRSP. This is notwithstanding that they have also benefited from earning tax sheltered income on a pre-tax investment.



In a nutshell, an RRSP helps reduce taxes in several ways.




If a taxpayer is in a 50% tax bracket, they would pay $5,000 tax on $10,000 of income.


But if they put that $10,000 into an RRSP, they will not pay the tax on that income right now.


Instead, when they are retired and are in a 20% tax bracket (for example), they can withdraw this $10,000 and only pay $2,000 tax.  Plus, they are paying $2,000 future dollars rather than $5,000 today dollars.  Plus, they would have had the benefit of having the entire $10,000 invested inside the RRSP to earn income over the years – giving them much more that they can withdraw in the future.




Buying with Pre-Tax Dollars


Using pre-tax dollars for investment or purchases leads to increased buying power. This is a very basic concept.  Consider a taxpayer in a 50% tax bracket.  If they earn $10,000, it turns into $5,000 after tax.  So, while they earned $10,000, after tax the taxpayer can only afford to buy something worth $5,000.  But if they could purchase something with pre-tax dollars, that $10,000 earned could buy them something worth $10,000.  This is the difference between buying with pre-tax vs. post-tax dollars.


There are ways to make purchases with pre-tax dollars vs. post-tax dollars.  For example, if a taxpayer purchases an investment in a vehicle such as an RRSP that allows one to use pre-tax dollars, then the amount invested can grow without being taxed until it is withdrawn.


Other contexts of using pre-tax dollars are when employers pay for specific benefits.


Most benefits one receives from an employer are taxable and considered to be “taxable benefits.”  A taxable benefit is a good or service one receives, from their employer such as a free use of a property. Other examples of taxable benefits are allowances or reimbursements of an employee’s personal expenses. And because they are taxable, being allowed to use the company car is treated by the CRA in the same way as if an employee were receiving the cash equivalent of a car lease.


However, exceptions exist, and some benefits are non-taxable. These include non-cash gifts in a year with a total value of $500; trivial gifts such as coffee or tea; educational allowances if schools in the area do not meet educational needs of a child, and the parents have to live in a specific location for that work; discounts on merchandise of the employer; disability-related employment benefits, such as transportation costs; a work cell phone; certain child care expenses; private health services plans (such as medical or dental plans); professional membership dues under certain circumstances; and so on.  So, it is possible for an employer to use their pre-tax dollars to give things to their employees in a way which does not cause the employee to have to pay additional tax.




If an employer pays $2,000 into a dental plan for an employee every year, and the employee uses that plan instead of paying for dental costs out of after-tax dollars, then their buying power has increased.


Consider that if an employee needs $2000 dental work, and if that employee is in a 50% tax bracket, they would have needed $4,000 of pre-tax income in order to afford the $2,000 of dental work.  But when the company provides the $2,000 dental plan which is not taxed in the hands of the employee, the employee is in essence able to buy that dental work with pre-tax dollars and increase their buying power.


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