Tax Credits vs. Tax Deductions

Tax Credits vs. Tax Deductions: Which Can You Claim?

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Last updated on March 21, 2021 Comments: 2

Ever wonder why Sherlock Holmes barely ever had to pay any taxes? He was a master of deduction, of course! The most exciting part of the rather drab tax filing affair is finding the ways to (legally) reduce your taxes with credits and deductions. Do you know the difference between the two?

A tax deduction reduces your taxable income while tax credits reduce your tax payable. Let’s dig into what that means and how you can use tax credits and deductions to your advantage.

What is a Tax Deduction?

Tax deductions are eligible expenses used to reduce your income tax

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Tax deductions are eligible expenses you can claim to reduce your taxable income. For example, if you made $65,000 last year and claimed $5,000 in approved deductions, you would only have to pay tax on a reduced taxable income of $60,000.

You’re probably already familiar with the Registered Retirement Savings Plan (RRSP) Deduction as one of the best tax-saving strategies in Canada. The more you contribute to your RRSP, the more you can deduct from your taxable income come tax time.

You may be eligible for some of these other common tax deductions, including:

What is a Tax Credit?

Tax credits can help you reduce the amount of taxes you owe.

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After you’ve added up all your deductions and calculated your reduced taxable income, you can further reduce your taxes with tax credits. There are two types of tax credits: non-refundable and refundable.

Non-refundable Tax Credits

Non-refundable tax credits help you reduce the taxes you owe. They are subtracted from your tax amount payable and are considered non-refundable because these credits don’t count towards a tax refund. If your total non-refundable credits are more than the taxes you owe, you will not get a refund for the difference.

For example, if you owe $1,000 in taxes and qualify for $250 in non-refundable tax credits, you would only owe $750 in taxes. If you owe $1,000 in taxes and qualify for $1,200 in non-refundable tax credits, you would owe $0 in taxes and the extra $200 would not be refunded.

The best example of the non-refundable tax credit is the Basic Personal Amount (BPA). Every Canadian is entitled to claim a non-refundable $13,229 BPA credit in 2020 to reduce your taxes owed, once applied.

You may be eligible for some of these other common non-refundable tax credits:

Refundable Tax Credits

Refundable tax credits are credits that the government will pay you if you qualify for them, even if you don’t owe any taxes. They’re considered refundable because if the amount of the credit is more than the taxes you owe, you will get a refund for the difference.

For example, if you owe $1,000 in taxes and qualify for $1,200 in refundable tax credits, you would be issued a refund of $200.

Governments may pass on these refundable credits to you in a series of payments throughout the year to help with living expenses, like the tax-free quarterly GST/HST Credit payment that helps individuals and families with low incomes offset the GST and HST that they pay. To continue getting payments, you need to do your taxes every year, even if you have no income at all.

Other common refundable tax credits can include:

How Do Tax Deduction and Tax Credits Actually Work?

How Do Deductions and Credits Work

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Canada uses a progressive income tax system, which means low-income earners are taxed at a lower rate than higher-income earners. We pay a combination of both federal and provincial income taxes. Let’s take a practical look at how your tax deductions and credits actually work using the federal tax brackets.

According to the Canada Revenue Agency (CRA), the federal portion of income tax for 2020 is calculated at the following rates:

15% on the first $48,535 of taxable income, plus
20.5% on the portion of taxable income over $48,535 up to $97,069, plus
26% on the portion of taxable income over $97,069 up to $150,473, plus
29% on the portion of taxable income over $150,473 up to $214,368, plus
33% of taxable income over $214,368

If you earned $48,535, you would fall into the 15% tax bracket and be subject to $7,280.25 in federal income tax. If you earned $65,000, the first $48,535 you earn would still be subject to 15% in tax and your next $16,500 would be subject to the 20.5% income tax rate. Based on this schedule, someone earning $65,000 would owe $10,655.58

Total Income$65,000.00
Taxable Income x 15% (on first $48,535, plus)$7,280.25
Taxable Income x 20.5% (over $48,535 up to $97,069)$3,375.33
Total Taxes Payable$10,655.58

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How to Calculate a Tax Deduction

A tax deduction will reduce your taxable income. As an eligible tax deduction, a $5,000 RRSP contribution would reduce the income subject to tax by $5,000. Your $65,000 income would now be considered $60,000 for your tax calculation. Instead of paying $10,655.58 in federal income tax, you’d now only owe $9,360.58. Your RRSP contribution would have generated $1,025 in tax savings and you’d experience similar tax savings at the provincial or territorial level.

Total Income$65,000.00
Minus RRSP Contribution$5,000
Taxable Income$60,000
Taxable Income x 15% (on first $48,535, plus)$7,280.25
Taxable Income x 20.5% (over $48,535 up to $97,069)$2,350.33
Total Taxes Payable$9,630.58
Tax Savings$1,025.00

How to Calculate a Tax Credit

Now let’s compare that with how a tax credit will reduce your tax payable. Tax credits typically generate federal tax savings based on the lowest tax bracket (15%). A $500 charitable donation tax credit will generate a $75 (= $500 x 15%) in credit against your taxes owing, regardless of your income bracket.

Total Income$65,000.00
Minus RRSP Contribution$5,000
Taxable Income$60,000
Taxable Income x 15% (on first $48,535, plus)$7,280.25
Taxable Income x 20.5% (over $48,535 up to $97,069)$2,350.33
Minus Charitable Contribution Credit$75
Total Taxes Payable$9,555.58

Take Advantage of Tax Credits and Tax Deductions

How Do Deductions and Credits Work

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If you’re in the lowest tax bracket, the value of a tax deduction is equal to the value of a tax credit, both are calculated at the 15% rate (the lowest federal tax bracket). Tax deductions become more valuable than tax credits when your income increases since deductions reduce your taxable income at your marginal tax rate.

Your non-refundable credits and deductions may leave you without any taxes due. Additional refundable credits may mean that you’re in for a refund from the CRA. For example, if you end up with no taxes due and qualify for a $1,000 refundable tax credit, you would receive the entire amount as a refund. With that in mind, it’s common practice to calculate your refundable credits after you’ve factored in all eligible deductions and non-refundable credits.

The availability of tax credits and deductions change from year to year. Just because they were available one year doesn’t mean they’ll be there the next- they are not guaranteed. For example, the 2020 tax year will introduce a $400 deduction to cover home and office expenses for Canadians working from home due to the COVID-19 pandemic. Similarly, a 2020 change in the way that New Brunswick handles carbon fuel charges will mean that residents of the province will no longer be eligible to receive the Climate Action Incentive credit.

All said and done, there are 95 different deductions, credits, and expenses that you can claim to reduce your taxes but unless you’re a full-time tax accountant, it’s nearly impossible to know if you’re making the most from your tax return. It’s hard enough to keep track of your eligibility, much less understand the information and forms you need to fill out. The right tax software, like Wealthsimple Tax, can go a long with to help optimize your return. Wealthsimple’s Refund Optimizer will run thousands of calculations to maximize your credits and deductions to reduce your tax payable. Once you’ve run the numbers, you can submit your return to the CRA for free or pay what you want to support a Canadian small business.

Tax deductions and credits are your best bet to reducing your taxes, and may even generate a tax refund. Just remember you’ll need receipts to back up your claims. You won’t need to send them in with your tax filing but you should keep them for six years just in case the taxman comes knocking for an audit.

Submit Your Tax Return with Wealthsimple Tax

 

Recommended Read: Canadian Tax Glossary – The Terms You Need to Know.

Author Bio

Daniel Teo
Daniel Teo is a personal finance expert and travel writer based in Toronto. With a passion for financial literacy and a wanderlust that has brought him to over 30 countries, his stories touch on what’s possible when you achieve financial goals. His work has appeared in The Globe and Mail, the Toronto Star, CBC and on BNN.

Article comments

2 comments
Neenous Shlaimon says:

I need help with my tax credit I am students college since last years please contact me I am ready with my documents number 647*** -*** Toronto Ontario…….please please give me call

Aaron Broverman says:

Hi Neenous,
I blocked your phone number here so it wasn’t publically available for anyone to call you. You need to speak to a tax preparer. Go to personaltaxadvisors.ca and reach out to Sunny. She is my accountant. She can help you. Tell her Aaron recommended her to you and ask her your student tax credit question.