Had a great year? Protect yourself from taxes with an RRSP.
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Freelance income can be a rollercoaster. When you get a great gig after a dry spell the relief of the new infusion of cash is a well-deserved rush. The only downside is the big spike in taxes that can be triggered by your good fortune. Luckily, RRSPs can be your ticket to protecting your money.
The feast-or-famine world of self-employment can be terrifying or exhilarating, but it can also be expensive when it comes to taxes. A person who earns $0 in one year and $90,000 the next will pay more tax than someone who makes $45,000 a year for two years.
The reason? The magic Marginal Tax Rates.
Most people know that when your income goes up, you pay more tax. What you may not know is that as your income passes certain benchmarks, the rate of tax increases so that you pay more tax per dollar earned — but only on the dollars above that benchmark. In other words, every dollar earned above one of these benchmarks is taxed at a higher rate than the dollars below. The rate at which your top dollar (the income ‘at the margin’) is taxed is called your Marginal Tax Rate, or MTR.
For example, one of these benchmarks might be around $43,000*. If you earn $44,000, that extra thousand dollars above the benchmark is taxed harder than your other income.
This is very important to freelancers and other self-employed people because it means that when you get a particularly juicy contract or gig, some of those extra dollars could get pushed above one of the benchmarks and get taxed extra hard.
The easiest solution for most people is to use RRSPs strategically to save tax.
RRSPs save you tax by temporarily sheltering your income from tax. For example, if you put $1,000 in your RRSP and claim the deduction on your tax return, your taxes will be calculated as if that $1,000 weren’t there.
But RRSPs don’t eliminate tax, they only defer it. When you take money back out of an RRSP, you pay tax on it as if it were just-earned income.
So when you get a great gig one year, one that pushes you past one of the benchmark, consider sheltering some of those marginal dollars in an RRSP. Even if you withdraw them the next (lower-income) year and have to pay the (lower rate) tax on them then, the total tax you pay overall will be less than if you had never made the contribution in the first place.
*The actual benchmarks shift up slightly every year, so this is not an exact figure.
There’s no particular advantage to purchasing a house in 2013 vs 2012.
While there is a credit for new home purchases, it doesn’t depend on your income (in other words, it saves you the same amount in a low income year as in a high income year).
What you definitely want to do if your income is high is to make as hefty an RRSP contribution as you can afford. That gives you a tax break that DOES depend on (i.e., increase in size depending on) your income level. Plus, if you want to make an RRSP withdrawal under the Home Buyers’ Plan, the money has to be sitting there for at least 90 days. Both good reasons to make the contribution as soon as possible.
(To get the tax break on your contribution, you must make it before March 1, 2014. You can withdraw up to $25,000 each under the Home Buyers’ Plan, so long as the money has been sitting in the account for at least 90 days.)