When you have a great year, sheltering an income spike with an RRSP contribution can save you excess tax.Click to tweet
Jargon Alert! Marginal Tax Rates
The feast-or-famine world of self-employment and freelancing can be terrifying or exhilarating. Unfortunately it can also be expensive when it comes to taxes. A person who earns $20,000 in one year and $70,000 the next will pay more tax than someone who makes $45,000 a year for two years. The culprit is a change in your Marginal Tax Rate, also known as your ‘tax bracket.’
Most people know that when your income goes up, you pay more tax. What you may not know is that the higher tax rate only applies to part of your income. The new tax rate only applies to the portion of the income that lies above the threshold. In other words, various parts of your income are taxed at different rates. Your highest tax rate – applied only to the portion of your income that is in the highest bracket – is called your Marginal Tax Rate (MTR). Sheltering income with RRSP contributions can take the bite out of a jump in your marginal tax rate.
For example, one of these benchmarks might be around $45,000*. If you earn $46,500, that extra $1,500 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 can push above one of the benchmarks and experience a higher tax rate.
The easiest solution for most people is sheltering income with RRSP contributions to save tax.
RRSPs save you tax by temporarily sheltering your income from tax.
For example, if you put $1,500 in your RRSP and claim the deduction on your tax return, your taxes will be calculated as if that $1,500 weren’t there. But RRSPs don’t eliminate tax, they only defer it. Balancing things out, when you withdraw the $1,500 from your RRSP, you pay income tax as if it’s new income in the year of withdrawal.
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.