It happens every spring. You might not want to, but you have to file your income taxes. Collect your documents, file through an accountant or online platform, and through some magical math you'll discover your fate: payment or refund.
If income taxes seem like a mysterious government equation, this episode is for you. Andrew Bauer (BA '03, MAcc '03, PhD '12) is a Canada Research Chair in Taxation, Governance and Risk. He's also an associate professor in Waterloo's School of Accounting and Finance, where he researches corporate tax and teaches courses in taxation and personal finance. He joins the podcast to tell us why we need to file our income taxes, the factors that could reduce the money you owe, and why you might not want a refund.
It happens every spring. You might not want to, but you have to file your income taxes. Collect your documents, file through an accountant or online platform, and through some magical math you'll discover your fate: payment or refund.
If income taxes seem like a mysterious government equation, this episode is for you. Andrew Bauer (BA '03, MAcc '03, PhD '12) is a Canada Research Chair in Taxation, Governance and Risk. He's also an associate professor in Waterloo's School of Accounting and Finance, where he researches corporate tax and teaches courses in taxation and personal finance. He joins the podcast to tell us why we need to file our income taxes, the factors that could reduce the money you owe, and why you might not want a refund.
It happens every spring. You might not want to, but you have to file your income taxes. Collect your documents, file through an accountant or online platform and, through some magical math, you'll discover your fate: payment or refund. If income taxes seem like a mysterious government equation, this episode is for you. Andrew Bauer is a three-time Waterloo alum and Canada research chair in Taxation, Governance and Risk. He's also an associate professor in Waterloo's School of Accounting and Finance, where he researches corporate tax and teaches courses in taxation and personal finance. He joins the podcast today to tell us why we need to file our taxes, the factors that could reduce the money you owe and why you might not want a refund. Andrew, thanks so much for joining us.
Andrew:You're welcome, Megan. Happy to be here.
Meg:Yeah, yeah, I'm happy to have you. I think that this is a topic that people don't really want to think about, and so they don't often dive into the details of it, so let's just start with the basics. Why do we have to deal with income taxes every year, and what are the main factors that determine whether or not we get a refund?
Andrew:Okay, real high level. One of the reasons why we have to deal with taxes every year is because we need money for public goods and actually, if you go back to the very first time we needed to worry about taxes, it was back in World War I. The very first Income Tax Act in Canada was called the War Measures Act. I have a little 100th anniversary copy of it and it's so tiny you wouldn't believe it relative to how big and voluminous the rules are now. But it basically said: Hey, this is a temporary thing, we need to raise revenue for the war effort. And 100- plus years later we still have it and we're still using taxes as a means of raising revenues for other things. So you might disagree or agree with different people about what we're raising revenue for, how effective it is, but basically that's why we have to do it. We've got public goods, we need to fund them and that's one of the tools that we use in Canada to do that.
Andrew:Another reason why we have to do this thing every year is because most countries around the world, including Canada, have a self-reporting system. Now there are countries in Europe, actually, that have been using more of an auto-filled tax return for a number of years, some maybe even 20 years. Now. Canada doesn't quite have that yet, but there's movement perhaps toward that where, if your income situation is very basic, the government will just fill out a return for you and you kind of just have to verify that it's accurate and you're done. But right now most of us have to at least put a few slips together that we receive in the mail or electronically and then fill out a return and file it and determine whether we're getting a refund, whether we owe some money at the end of the year.
Meg:Yeah, and so income is the main determining factor about whether or not you have to pay or whether you're going to get a refund. Can you break down all of the main factors?
Andrew:I can try and break down a few. I think and this is a bit of my opinion but in Canada the system is kind of set up to give you a refund, and actually I was looking at some stats about 58% of people that filed their tax return in 2023 received a refund, and maybe slightly less than a quarter of the people actually had to pay, and so then the remainder of the people had. They just had no balance owing. Part of the reason it's set up to give you a refund is the way in which you can -- So most of us are just, we're employees. That keeps things relatively simple, means your employer does a lot of the withholding of taxes. That determines whether or not you've overpaid at the end of the year when you fill out your return or not. If you've overpaid, you get a refund, and in Canada, the work you have to do to get your employer to withhold less tax is a little bit more than in some other countries.
Andrew:I can compare to the US, having lived there. It is relatively easy to fill out additional information. Tell the US about when you're filling out your payroll forms. Okay, well, in addition to basic stuff, here's some other things about me that might reduce how much tax I'm going to owe when I fill out a loan, fill out a return at the end of the year. In Canada you do have a form like that that you fill out when you begin a new job or maybe, or you can update your employer as something changes in your life, but it's mainly just listing out a few credits that are kind of standard and that doesn't account for all the different situations that could come up. Those different situations, if they come up, you got to file this other form and it's on you, the employee or the individual, to do it.
Andrew:Most employers that I'm aware of don't reach out to employees and say: "Hey, if you want to reduce your tax withholdings, don't forget to fill out this form, send it to us in the CRA and then we'll take care of it. But if you did fill out that form things like contributing to an RSP, which a lot of people do that would be on there. But because people don't fill that out and they do contribute it to an RSP, they get a deduction that they're entitled to but it's not factored into their pay, each pay periods withholdings. So at the end of the year they have this deduction that hasn't been accounted for. They put it into their tax return.
Andrew:You do the math, you end up getting a refund. Some of the other things that are in there are childcare expenses, donations, medical expenses. So, again, if you're not filling out this form, it's called T-1213. You're not able to take advantage of some of these other things that will reduce your tax liability, and so you end up just paying the standard amounts that your HR reps think you're supposed to pay, and then you end up figuring it out at the end of the year when you do all the calculations.
Meg:Yeah, that's a good overview, and so we've talked a bit about refunds. Most people, when they file their taxes including myself up to this point file hoping to get a refund. We don't want to pay more money, right, but you don't hope for a refund.
Andrew:Why not? Well, I'm strange, that would be the first thing to say. I'm strange because I'm highly economically rational when it comes to taxes. And so, if you think about it, if you're getting a refund at the end of the year, what you're getting is your money back. Let's say you have a very simple situation: all you have is employment income and you've got an RRSP and you didn't fill out this form, so you pay some tax. It's coming off of your employment income and then at the end of the year you determine oh, I've overpaid a little bit, so now I'm going to get it back. So that's money that was yours, you were entitled to, right? Once you started working. You were earning that money, but instead of getting it paid to you, each pay period, a little bit extra that belonged to you was getting sent to the government, which maybe is fine with you, and actually I don't mind paying taxes at all.
Andrew:But I only want to pay what I owe and I would rather, instead of getting my refund at the end of the year, when the government is going to give me a small amount of interest, maybe for the period between the time that I filed my return and the time they finished processing it. I would rather have my money all year round so that I could do what I want with it. I can invest it and I earn a better return than the government's going to give me. I could just take it out back and burn it. Whatever, it's my money right.
Andrew:It's up to me to do what I want to do, and I would rather have it at the time that I should be getting it to make the choice that I want to make. So I look at it as an interest- free loan that I'm not really all that excited about giving the government. I'd rather have it to myself to do what I want to do with it. So that's why I don't like refunds. My wife, she's the opposite. She's like: "where's my refund? But I try and pay just a little bit, not a lot, just a little bit, yeah.
Meg:And there's a form that you can fill out if you wanted to reduce the likelihood of getting a large refund. If people decide that they, like you, want that money to burn it or whatever they'd like to do throughout the year, there's a form and you just contact the CRA, right, yeah?
Andrew:I mean there's a couple of forms. The first one that everyone fills out is something called a TD1. So when you're an employee, you fill this out, you give information about credits that you're eligible for. Most of us that's like a basic credit, maybe something to do with if we have a spouse or children. As we get older there might be something in there for age, but that's about it. Students they might be able to add something for tuition and that alone, depending on how low your income is, might get you into a refund position if your employer isn't otherwise adjusting the tax withholding tables.
Andrew:But once you're earning a decent wage or decent salary, the way to adjust your withholding, as you mentioned, is to file a form. It's this other form, this T-1-2-1-3 or T1213, where you put in information about here's what my salary is, here's how much I'm contributing to my RRSP, here's how much I'm paying in childcare expenses, here's how much I'm planning to donate, and you file that form with the CRA. You include some information about your employer, your HR department, and then, if the CRA approves it, they contact HR at your employer and say, hey, this person's approved to have lower tax withholdings. Please make the necessary adjustments. And that's a form that you have to fill out every year, though, to continue to update the CRA and your employer about what you're going to do, because maybe the amount that you donate changes from year to year. Maybe the amount that you're contributing- to your.
Andrew:RRSP is changing and so you have to sort of keep them updated on what your current status is. So that does. Again, there's one piece of admin work is you have to do the upfront contact. Two is you've got to keep it updated every year, whereas this other standard form, the TD1, your employer will tell you when you begin work with them, hey, you got to fill this out and they'll just keep that on record every year and not make any changes unless you update them, so that TD1 is easy to do. Standard. The T1213 takes a little bit of extra work and probably a lot of people are not even aware that that's an option available to them. Yeah, I had no idea.
Meg:So very interesting to learn that you have options about these things. You don't just have to wait until the spring every year to see what's happening. So you mentioned earlier that RRSPs also play a role in taxes, and so, really, tax deductions can play a big role when you're deciding where to put your savings, and there are three different options. You have the TFSA, the tax-free savings account, the RRSP, the registered retirement savings plan, and, if it's offered by your employer, you could also pay into a pension. So what are the benefits of each of these when it comes to taxes?
Andrew:Well, they're all great let's start by saying that. And they're all under the right conditions, equivalent to one another, but under different conditions they could be better or more or less effective, but still better than pretty much anywhere else you could put your money. So you really ought to get your money for your future savings into one of these three vehicles. So if your company has a pension, you really want to start contributing to that or opt into it. If they don't, an RRSP is great. If you're thinking TFSA, that's great too. So, and there's other plans out there we won't really talk about. Well, we'll talk about one later. That's super awesome, but I mean, the basic reason why these things are all amazing is because they offer ways for you to save for the future while deferring tax or minimizing the tax that you would owe. And these aren't available to you just by plunking your money into a savings account, just by putting your money into a GIC on its own. So basically, what's happening with each of these things the TFSA, the RRSP and the pension is, while your money is in that plan, it is earning tax-free, so the growth in there is pre-tax. You don't have to pay any taxes while your money is sitting in the account. The difference between them is whether you get a deduction when the money goes in and whether you pay tax when the money comes out. So the TFSA it's the most flexible of these plans because you can put money in pretty much at any time. You can take money out at any time. You don't pay tax on anything that comes out, neither the contributions you provided or the earnings. So that really makes it simple for people. They don't have to think about it.
Andrew:Now there are limits to how much you can put in every year, but that limit just accumulates if you don't max out. So this year, for example, the limit is $6,500. You don't contribute anything to your TFSA this year and perhaps this is the first year you qualify to open one. Next year, if the limit continues to be $6,500, you can put in $13,000, all of 2023's limit and all of 2024's limit. And the RRSP is like that too. Any contribution room you don't use up in the year carries forward. It's available in a future period. Pensions don't have that. Use it, don't.
Andrew:So with the TFSA, you're putting in after- tax dollars and then, because of that, you don't pay any tax on the contributions when they come out, and again you're not paying any tax on the earnings, so it sounds tax-free, right? You're like I put money in, I take it out, there's no taxes. Tax-free. But again you put in after- tax dollars and you didn't get consideration for that. If you put money into your RRSP, you get a deduction for that. Then the money is in there, it's growing. After you invest it, it's not paying any taxes and at some point in the future when you take the money out, you've got to pay tax on the earnings and you've got to pay tax on the contributions.
Andrew:But if you face the same tax rate today when you contribute as you face in the future when you take the money out, from an economic standpoint you are completely indifferent between whether your money went into a TFSA or whether your money went into an RRSP. You will get the exact same amount of after- tax dollars. I love doing the algebra on it. We do this with my students in class. I think some of them like it too, because they're in the math program. Others maybe, who are more artsy, don't find it as fun, but it's a mathematical fact. So if your tax rates are constant over time, you really don't care from an economic standpoint about a TFSA or an RRSP and a pension is basically working like an RRSP, where you put money in. Now you get a deduction or you get to exclude that amount from your income.
Andrew:So the contributions have gone in pre-tax and then the money comes out in the future after facing no tax while growing, and you pay tax on the contributions and the earnings. So the difference then is okay, well, what if my tax rates aren't the same? So oftentimes you'll hear people who have low tax rates told to invest in a TFSA, which makes sense, because if your tax rate is really low now and then your tax rate is going to be higher in the future when you take the money out, you're better off putting in after- tax dollars, which are essentially not taxed now, or low- tax now, and then taking the money out in the future. Everybody else who's taken out of their RRSP is maybe paying tax at a higher rate. You don't have to pay any tax because your money's coming out of TFSA, so you're better off that way.
Andrew:On the flip side, once you start earning a decent living and your tax rate is increasing, we generally expect those that are contributing to tax advantage plans while they're working to when they retire and need to take out of those plans, to be paying tax at a lower rate. And so because your money's going in when you're facing a higher rate and getting a bigger deduction then, and it's coming out at a time when you're facing a lower rate and you're less taxed to pay. You're better off going the opposite way. So for some people, choosing between the TFSA or the RRSP is a question of how do you expect your tax rates to be? What are they now? What are they going to be in the future? So students and low-income earners TFSAs are usually the first place to go. But those who are in a steady position earning a decent amount of income, they're better off using an RRSP first. But if you got enough cash lying around and it's not easy to find that, but if you did in any particular year maximize them both. They're both great.
Meg:Yeah, that's a great breakdown. I love how you broke down the different stages in your life. It's not necessarily something that you want to start paying into when you're in your 20s and then you continue all the way through. Maybe that makes sense for you, but for some people it might change throughout your career, which is a good consideration.
Andrew:Yeah, and I think that's also where you want to think about some of the non-tax parts of these plans. The TFSA, as I mentioned earlier, is really flexible Put the money in, take it out. As long as you're not exceeding your contribution limits, I mean you can do whatever you want with it. You can invest in the same types of things in your TFSA as you can put in your RRSP or your pension. That's really great. If you're invested in a TFSA for a number of years, you're planning to use it for retirement, but then something happens in your life and you need to take the money out. You can take it out. You're not having to think about filling out any additional tax forms or providing any additional information on your tax return. It's quite simple. In addition, when you take the money out, that gives you extra contribution room next year.
Andrew:If you take the money out and then you want to put it back, you get that bonus contribution room in addition to whatever the annual contribution amount is. Every year there's an annual contribution amount that everybody gets. With an RRSP, if you put the money in, you plan to use it for retirement, something comes up and you want to take it out, you can, but you will have to pay tax on that. You're going to have to make sure that you include the forms and do the work on your tax return. In addition, you don't get additional contribution room to say, "Hey, I took out $10,000 this year. This year I get my regular contribution room plus $10,000. That's not how it works. The TFSA is pretty unique in that sense. The pension it's the least flexible. It's generally not controlled by the individual. You can't start drawing from it until you're in retirement or at a retirement age.
Andrew:Once the money is in there, it's pretty much set. That may be one reason why someone who works for a company with a company pension plan says you know what, I would rather contribute to an RRSP instead, or I would rather contribute to a TFSA, because those give me more flexibility. There are many employers who will match contributions to an employee's RRSP plan. If your employer does that, that's a great option for you to have in addition to considering that company pension.
Meg:Yeah, all great points you mentioned earlier. My last question is whether you have any other tax advice for young adults. I suspect that you're going to mention the homebuyer's saving plan, because you mentioned earlier savings plan. That's really great and has lots of benefits. This one's new. Can you tell us about that?
Andrew:Yes, that's the one I really want to talk about the first home savings account (FHSA). It's brand new as of 2023. It was announced, I think, in the 2022 budget, that the federal government was thinking of initiating this plan to help people purchase their first home. It became part of law in 2023. Federal institutions I think since either April or May, possibly June, have been allowing individuals to open one of these accounts.
Andrew:The first home savings account is basically a combination of the TFSA and the RRSP. It has all the best things about the two of them. When your money goes into a FHSA that's the short form you get a tax deduction. Now the money is in the account, invested in, hopefully, things that are providing a good return. You're not paying any tax on those earnings. Then, when you take the money out in the future, hopefully to be able to put a down payment on that home that you want to purchase, you don't pay any tax on that. So the money's tax-free going in because you get this deduction. The money is tax-free while you're earning in the plan and then, assuming that you use the money to purchase a home, it's tax-free coming out. You can't beat that anywhere. I'm not aware of this existing in any other countries in the world. Not like I've canvassed all of them, but like this is a pretty cool thing. The other really cool thing about this FHSA is that let's say you decide in the future that home-owning isn't for you, or you're not ready, you know, or you don't have enough saved up.
Andrew:You can move that. Whatever you've contributed to it, you can move it over to your RRSP, and you don't as long as you've got an RRSP set up, you basically can just transfer it in there and then it just becomes part of your RRSP pool. When the money comes out in the future from your RRSP in retirement, you will have to pay tax on the contributions and earnings, but that's no different than if you were just making a regular contribution to an RRSP. The bonus is that you know your RRSP, you generate room by working, by having earned income. But in addition to generating the room in your RRSP through your earned income, once you open an FHSA you get additional room if you need it to move into your RRSP. You don't have to have existing contribution room to transfer from your first home savings account into your RRSP. You just have to have both of them open. And actually you can go the other way too, you could have an existing RRSP.
Andrew:So maybe this is for people that have already been contributing to an RRSP at this point in their lives and they don't own a home and they're thinking, "hey, this might be really great, I'm going to open a first home savings account. They can transfer money from their RSP into their FHSA. And so there are limits. There's basically, you can have this FHSA open for 15 years and you get a $40,000 worth of contribution room over that 15 years. They're giving you annually $8,000. So in the first five years you basically come up with your whole contribution room, but if you haven't maxed out, you continue to carry that room forward.
Andrew:So in a sense, you get to put $40,000 away tax-free into this account, let it grow as big as it can, and then you can pull the money out when you want to buy a home up to 15 years later from opening it, and so that could be a substantial amount of savings that you've accumulated. You know, for people that are buying a house with a significant other, if they each have a first home savings account, then that's double the amount of money. In addition, the RRSP offers you an option to take money out of it as well under something called a home buyers plan and you can combine both of them so you could have a first home savings account, you could have an RRSP and you could take money out of both. Each of them. Those withdrawals are tax-free to put towards a down payment on a home, so it's super awesome.
Andrew:I would have to say, if I was a young person right now, the first place that I would put my money would be a first home savings account, not the TFSA, not the RRSP. That's assuming that you think home ownership is in your future and you want that to be something to aspire to. If that's the case, open that first home savings account, put the money in there. Like I said, it's the best of both worlds tax-free, going in tax-free, coming out tax-free. While the money's in there, it's unbeatable. So you might as well take advantage of it.
Meg:Wow, it is not too good to be true, it is true, it is true, it's pretty amazing.
Andrew:I was surprised when I heard about this thing and a number of us that are interested in tax at all. Well, you probably won't be able to combine this first home savings account and the home buyer is playing out of the RRSP. And then they said no, you can do it. Oh my gosh. Wow, just the bonuses keep coming. So it's a really nice thing to have available to you. Hopefully it's going to make a difference in people being able to save those down payments, because we know it is pretty tricky to afford houses these days in Canada. So hopefully this thing is going to make a difference.
Meg:Yeah, that's great, Andrew. It has been great to talk to you today, and I know I've learned quite a bit about taxes from you, so thanks for joining.
Andrew:Glad to share.
Meg:Thanks so much for listening. If you enjoyed this episode, please subscribe to our feed. If you want to learn more about finances, career paths or other practical topics, check out our list of upcoming events for alumni. Thanks to alumni volunteers, we host events all over the world. Follow the link in our episode description to learn more. You Waterloo alumni podcasts are produced and hosted by me, meg Vanderwood. I also happen to be a proud alum. Thanks to Angle Media for editing this episode.