Preparing for The Tax Impact of CERB
The Canada Emergency Response Benefit (CERB) was created in March 2020 to provide support to those Canadians unable to work due to the COVID-19 pandemic.
Both employed and self-employed Canadians who qualified for CERB could receive $500/week for up to a maximum of 24 weeks for a total of $12,000. Of note, although the CERB benefit is now closed (as of September 26th, 2020), Canadians may still apply for backdating, and the government is currently looking at making changes to the Employment Insurance (EI) program in addition to a new recovery benefit program which is currently before Parliament. Should the new program pass through the House of Commons, new benefits will apply retroactively to begin as of September 27, 2020. It’s important to remember that these CERB payments are not tax free. Even though the government sent out CERB cheques without taking any withholding tax, they are taxable benefits that individuals will be required to pay income tax on come April 30th, 2021.
Let’s consider several individuals with different income levels:
Consider individual A. They expect that CERB income will be their only income for the year. Therefore, there will be no taxes payable (due to tax credits that eliminate it at that income level).
Individual B expects to earn $32,000 in 2020 made up of $20,000 from regular employment/self-employment income and $12,000 from CERB. To calculate the tax impact of his CERB payments, B will need to figure out the marginal tax rate on his entire expected income for the year. With expected income of $32,000, B’s marginal tax rate will be 25%. By multiplying the CERB payments by the marginal tax rate, B arrives at an additional taxes payable figure of $3,000 (i.e. $12,000x25%).
We use the marginal tax rate because it is the amount of tax that an individual would pay on an additional dollar of income. That tax is based on our federal and provincial system of graduated tax rates, which “gradually” goes up as income increases. For example, federally in 2020, individuals pay 15% in taxes on their first $48,535 of income, 20.5% on their next $48,534, 26% on their next $53,404, 29% on their next $63,895, and 33% on anything over $214,368. Then the provinces add in their own graduated system.
Looking again at our chart above, Individual D who expects to make $112,000 this year is in a tax bracket where her marginal tax rate is 36%. This means every additional dollar of income is taxed at 36%. Therefore, for the additional $12,000 in CERB payments, $4,320 should be set aside for taxes ($12,000x36%).
You can easily estimate your own potential tax liability by using the same calculator we’ve been using to estimate taxes. You can find it right here at this link: Tax Calculator.
Now that you know what your potential CERB tax liability is, what should be your game plan?
Many wonder if making an RRSP contribution would be a good idea. If you make a $12,000 RRSP contribution to match your $12,000 in CERB payments, you’ll eliminate your tax liability. But here’s something to consider. One of the great advantages of an RRSP is that it allows you to defer paying taxes on today’s income until you retire, while at the same time benefiting from compounding tax deferred growth from investments over that same time period. Another advantage is that often you contribute to an RRSP during periods of high income and then withdraw from your RRSP in retirement when your income requirements are lower. If that move from high income to lower income results in the retiree being in a lower tax bracket, they get a second benefit from the RRSP. They pay less marginal tax as a retiree on the same amount of income that they would have paid a higher level of tax while they were working.
So, if this is a low-income year for you as a result of COVID-19, consider whether the marginal taxes you are forgoing this year due to the RRSP contribution may be less than your marginal tax rate in retirement. If that’s the case, you may want to skip the RRSP contribution, pay your taxes out of cash, and save your RRSP contribution room until you’re in a higher tax bracket, particularly if you expect your income to bounce back in 2021. Further, if you do have additional cash to invest, this may be a great year to contribute to a TFSA or to pay down your mortgage.
Looking at our 5 individuals above, this consideration should definitely apply to A and B, and potentially C and D if their income is continuing to rise and they expect to move up tax brackets in the near future. Individual E is in the top marginal tax bracket already so would definitely get the full benefit of making an RRSP contribution.
Regardless, of whether you are going to be contributing to an RRSP or not, there is still a future tax burden (from CERB) that needs to be addressed. If you haven’t done it, may we suggest starting a monthly contribution right away because let’s face it, April 30th, 2021 will come faster than any of us expect. It always does.
If you’d like to discuss this topic further or set up or increase your monthly investment, please call us at (780) 426-2400, or e-mail us at email@example.com to schedule an appointment.