TAX CREDIT SAVINGS A HIDDEN BENEFIT.

Monday’s meeting of federal, provincial and territorial finance ministers in Vancouver ended with an agreement to increase Canada Pension Plan benefits for future generations, beginning in 2019.

Under the new system, target income replacement would rise to one- third of pensionable earnings ( from the current 25 per cent) and the maximum amount of income subject to CPP would increase by 14 per cent, which is projected to be equal to about $82,700 in 2025.

As part of CPP enhancement, the government announced a surprising, but welcome, tax change. Beginning in 2019, employee contributions associated with the enhanced portion of CPP will be eligible for a tax deduction instead of the current tax credit. This is being done “in order to avoid increasing the after-tax cost of saving for Canadians.”

To better understand the issue, we need to take a closer look at the difference between tax deductions and credits. Tax deductions are amounts that you can deduct from your total income to arrive at your taxable income, which is the base for calculating the amount of tax that is payable. Since income tax is levied at graduated, “progressive” rates, such that higher tax rates apply as your income level increases, a tax deduction yields tax savings at your marginal tax rate that varies with your income level.

On the other hand, tax credits directly reduce the tax you pay. With tax credits, a fixed rate (15 per cent, federally) is applied to eligible amounts, such as current CPP contributions and EI premiums, and the resultant credit amount offsets taxes payable. When you add provincial tax savings to the federal savings above, the total tax savings from a combined f ederal/ provincial credit ranges from 19 per cent to 26 per cent, depending on your province or territory.

To illustrate the difference, let’s examine how the current federal tax system treats a $1,000 RRSP contribution, compared to $ 1,000 of CPP premiums for a taxpayer who earned $50,000 of income in 2016.

The RRSP deduction of $ 1,000 is subtracted from income, so that this amount of income is not ( currently) taxed. At 2016 federal rates, a $1,000 tax deduction yields $ 205 of tax savings, calculated as the $ 1,000 deduction multiplied by the federal marginal tax rate that would have applied to the income (20.5 per cent). Consequently, an RRSP contribution leads to a deduction and yields tax savings at your marginal tax rate.

By contrast, when you contribute $ 1,000 to CPP, you got a non- refundable federal credit for $ 1,000, which is worth only $ 150 at the current 15- per- cent federal credit rate.

Since the tax savings from a tax deduction are based on your marginal tax rate, a tax deduction can provide greater value for those who have higher levels of income, whereas a tax credit, which is based on a rate that is fixed for all taxpayers, yields the same value regardless of income level or marginal tax rate.

But, at the end of the day, both RRSP withdrawals and CPP benefits will be taxable when received, as they will be included in your income at your marginal tax rate. Therefore, perhaps a case can be made to allow all CPP contributions to be tax- deductible and not restrict deductibility to the additional employee contributions associated with the enhanced CPP. This would provide more appropriate and fairer tax relief to middle- and higher- income Canadians trying to save for retirement, especially if, given a limited budget for savings, individuals reduce their tax-deductible RRSP or pension plan savings in light of the new, mandatory increased CPP contributions.

GOVERNMENT ANNOUNCED A WELCOME TAX CHANGE.