Earned Income and Your RRSPs
Hello All,
In honour of Canada day, I thought it would be very exciting to discuss tax concepts that you can then share with your friends and family perhaps at a celebratory barbecue or party (this is particularly effective if you want some alone time:))
The idea of earned income is important largely as it relates to Registered Retirements Savings Plans (RRSPs) contribution room and is closely related to active income. RRSPs, as you might know, are the single most effective tax savings vehicle available to Canadians. As such, ideally, you want to maximize the amount that you can contribute each year. This is beneficial, even if you can’t contribute the full amount, as your contribution room is cumulative i.e. anything you don’t contribute gets carried forward to a future year.
So, how do you earn contribution room? Revenue Canada (CRA) calculates this at 18% of earned income. The definition of of earned income according to CRA:
We calculate your earned income by adding your employment earnings, self-employment earnings, and certain other types of income, then subtracting specific employment expenses and business or rental losses.
This means that salaries/wages that you earn as an employee (full time or part time), unincorporated business income, commissions, tips etc. It also includes royalties, research grants and alimony. Interestingly, it also includes net rental income which is usually considered to be passive income in other tax contexts. It does not include investment income such as interest, dividends and capital gains. In other words, income earned on assets (except rental income) does not increase your RRSP contribution room.
Unless you are a business owner, the way in which you earn income is (unfortunately) not flexible. You can’t really ask your employer to pay you dividends instead of salary. Nor can you ask your broker to pay you a salary instead of capital gains.
If you are an incorporated business owner, the most important impact is how you decide to pay yourself . A salary will be considered to be earned income and will therefore result in RRSP contribution room calculated at 18% of the total salary (up to a maximum of $171,000 of salary or $30,780 of contribution room in 2023). A dividend, on the other hand, does not result in any RRSP contribution room since it considered to be passive investment income (dividends are paid to shareholders while salaries are paid to employees).
I advise everyone to know their RRSP cumulative contribution room as this will allow you to make an informed decision when you do decide to contribute. Even contributing a little can go a long way towards your retirement goals (and reducing your tax bill!).
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