Tax efficient moves for those who are self-employed

If you have decided to quit your 9 to 5 job and take the plunge into being self-employed, then a big congratulation to you. It is indeed a big decision and you need to keep a lot of things in mind, especially related to income tax.

People in traditional employment often take for granted the convenience of income taxes being automatically deducted from their pay cheques, the stability and predictability of their earnings, and the reliance on a single income source.

Self-employed individuals shoulder the responsibility of meticulously tracking and reporting their own income, expenses, and, in many instances, sales taxes on their goods or services. This remains applicable regardless of whether they are formally registered as a "sole proprietor" or earning an independent income without any employer affiliations.

Having a clear understanding of what constitutes business income and business expenses is crucial to fulfilling your tax obligations. Form T2125, provided by the CRA (Canada Revenue Agency), offers an exhaustive list of tax-deductible items for individuals earning self-employment income. Among its 21 categories, you'll find eligible expenses like rent, utilities, property taxes, meals and entertainment, office supplies, fuel costs, travel expenses, and various others.

Self-employed Canadians can deduct these permissible expenses from their total earnings when calculating their taxable income. This deduction mechanism reduces the tax burden, making it beneficial for them to spend on approved expenses. However, it is crucial to note that including these items in your deductions requires maintaining appropriate records.

It is also really important to meticulously keep all your records safe to support your claims for tax deductions. By adhering to these guidelines, self-employed individuals can optimize their tax saving while staying compliant with CRA regulations.

One of the most common misconceptions among self-employed people is that a bank statement or credit card statement would be enough to show to the CRA. This is not true. The CRA asks for original bills and receipts from all your suppliers.

While many expense categories have well-defined distinctions between business and personal costs, some fall into a grey area that blurs the lines. In such cases, self-employed taxpayers bear the responsibility of determining the portion of the expense that qualifies as business-related. It is crucial for self-employed individuals to carefully assess these ambiguous expenses and accurately calculate the proportion that legitimately pertains to their business activities. This diligent approach ensures compliance with tax regulations and helps maintain the integrity of their financial records.

Ensuring that you claim all your business-related expenses on your tax return is not only beneficial for reducing your payable tax but also for creating a comprehensive and accurate overview of your business’s overall financial health. By claiming all eligible expenses, you gain a clear understanding of your business performance and ensure that you are maximizing the tax deductions available to you.

Split your income or pension with your spouse

Similar to how contributing to RRSPs can reduce your taxable income, income splitting offers another valuable opportunity to save on taxes. Income splitting allows for the transfer of funds from a higher-earning spouse to their lower-earning partner, aiming to provide the latter with additional investment income.

By utilizing a spousal RRSP, this financial strategy helps optimize the overall tax situation within a household, potentially resulting in lower combined tax liabilities. This approach is particularly beneficial when there is a significant income disparity between partners, making it an effective tool for maximizing tax savings and enhancing overall financial well-being.

Income splitting can occur before and during retirement through two common methods: spousal RRSPs and pension splitting. With spousal RRSPs, the higher-earning partner can contribute to the RRSP of their lower-earning spouse, staying within the allowable contribution limit. This transaction offers a twofold benefit for the couple. Firstly, the higher-income spouse can claim a tax deduction in the year of the contribution, potentially reducing their overall tax rate. Secondly, when funds are eventually withdrawn from the lower-income spouse's RRSP during retirement, the tax liability on the withdrawal may be reduced since it will be taxed at the lower-income spouse's tax rate. By strategically using spousal RRSPs, couples can optimize their tax situation, leading to potential significant tax savings throughout their financial journey.

Utilize RRSPs, TFSAs, and RESPs

One of the best tax efficient moves is to utilize tax deferred investments like -Registered Retirement Savings Plans (RRSPs), Registered Education Savings Plans (RESPs) and Tax-free Savings Accounts (TFSAs). Each plan defers or mitigates tax obligations in different ways.

An effective way to reduce your taxable income is by regularly contributing to an RRSP. You can contribute up to 18% of your earned income from the previous year to your RRSP, with an annual maximum limit (e.g., $27,830 for 2021). The money you invest in the RRSP can grow tax-free until you choose to make a withdrawal.

As these funds are meant to support your retirement, the key strategy is to make withdrawals during your retirement years when your income – and hence your tax rate – may be lower. This approach maximizes the advantages of the RRSP, ensuring you optimize your savings and experience a more tax-efficient retirement.

In 2021, the maximum annual contribution for TFSAs is $6,000. TFSAs operate by using after-tax income for contributions, and the most appealing aspect is that no taxes are applied when you decide to withdraw your funds, allowing your investments to grow tax-free. TFSAs offer greater flexibility compared to RRSPs: Investors can access their funds depending on the type of investment, and any amounts withdrawn can be recontributed in a subsequent tax year. This flexibility grants you greater control over your savings, making TFSAs an appealing option for individuals seeking tax-free growth and easy access to their funds.

RESPs offer a valuable way to save for a child's post-secondary education, along with the benefit of saving on taxes. Like RRSPs, investments within the plan can grow tax-free, and the growth is usually taxed in the hands of the recipient – the student – whose tax rate is typically lower than that of the contributor.

Moreover, the federal government extends a helpful incentive called the Canada Education Savings Grant. Under this program, the government matches 20% of up to $2,500 in RESP contributions annually, reaching a lifetime maximum of $7,200. This generous grant provides an extra boost to your savings efforts, making RESPs an attractive and efficient way to secure funds for your child's education.