Financial Planning for Exempt Income

Approximately three years ago I met an Indigenous individual who I will call Tracy who asked me for help.?Tracy is a status individual who ran a very successful business on a reserve and she had questions about her investments and retirement planning.?Tracy was advised a number of years ago by someone at her local bank that she should be open a RRSP account and invest in their brand of funds.?The bank employee advised that the funds will grow tax free each year and when she retires and starts to withdraw funds she would be taxed on the withdraws, but she would most likely be in a lower marginal tax rate.?For most investors this would be correct, but in Tracy’s case this was bad advice.?Before I review the particulars of Tracy’s circumstances, a refresher of what RRSPs are might be helpful.?

Registered Retirement Savings Plans (RRSPs) were first introduced in 1957 as a mechanism to encourage Canadians to save for retirement.?The maximum an individual could contribute back then was $2500.?Today, you are allowed to contribute up to 18% of your “earned income” from the prior year to a maximum of $30,780 for 2023, minus any pension adjustment, plus any unused contribution room from prior years.???The advantage of RRSPs are that the funds will grow tax free and when you withdraw the funds, presumably when you retire, you will likely be in a lower marginal tax bracket.?There are many myths about why someone shouldn’t invest in a RRSP, but that’s beyond the scope of this article.?For a full explanation see Jamie Golombek’s article, “In Defense of RRSPS: Dispelling common myths”?

The key phrase in the above paragraph, is “earned income.”?What is earned income??Earned income are the following:?employment income; sole proprietorship income; net rental income from a rental property; CPP or QPP disability benefits; and taxable alimony received.?In other words, if you don’t have any of these types of income you won’t be able to build any RRSP room.??Other types of income that don’t earn any RRSP room would be investment income (interest, dividends, capital gains); pension income; retiring allowances; death benefits from insurance policies; money received from RRSPs or RRIFs.

The vast majority of Canadians have employment income and are able to build RRSP room.?As noted above, the more earned income you have the more RRSP room you can build.?For Canadian investors; if you don’t have any earned income, then you won’t earn any RRSP room and you should not be investing in RRSPs.?To determine how much RRSP room you have each year, you can refer to your Notice of Assessment (a Notice of Assessment is what you receive each year after you file your tax return).

Under Section 87 of the Indian Act employment income for Indigenous individuals is considered exempt only if the income is situated on a reserve.?If the employment income is exempt from tax, you do not have to include that income when you file your personal income tax return.?

To determine if an Indigenous individual’s income is exempt can be a complicated process. If you are an employee, your employer will enter your tax-exempt earnings in box 71 of your T4 slip. For self-employed individuals the determination of exempt income is dependent on many factors and it’s best to consult with your accountant and/or Canada Revenue Agency (CRA), but generally the following two criteria must be met:

·????????The person in question is status;

·????????The income earned is on a reserve (again this can be a complicated question to answer, so it’s best you talk to your accountant or other professional).

Under Section 87 only status individuals qualify for exempt income,

For a full description of what income is tax exempt for status individuals and what isn’t click?HERE

With respect to Tracy’s circumstances, the following applied:?

·????????Tracy is a status individual;

·????????All of her income was earned on a reserve.?Note, the income earned does not have to be their reserve, it can be any reserve.

Since Tracy’s income was all exempt income there is a significant difference between what types of accounts she can invest her money in:?RRSPs; Registered Pension Plans; TFSAs.??

RRSPs

In Tracy’s case since all of her income was exempt income, she didn’t have any RRSP room.?Tracy unfortunately didn’t check her Notice of Assessment to determine if she had any RRSP room, nor did the bank employee suggest she do so before contributing the money.?Since Tracy over contributed to her RRSP she ended up having to pay a penalty of 1%/month on the amount she had over contributed as per Section X.1 of the Income Tax Act. ????

When an investor takes funds out of a RRSP a T4 RRSP is issued by the financial institution to the individual as well as to CRA or in the case of funds withdrawn from a RRIF account a T4 RRIF is issued.?When the investor files their tax return the following year, they are expected to claim their income and the corresponding tax is then payable.?

When I first met Tracy, she had been investing in RRSPs at the bank for a number of years and had built up a sizeable amount.?After some research, Tracy was concerned that when she withdrew the funds from the RRSP that she would be taxed on it.?As noted above, since all of the income she received was exempt then the money withdrawn from the RRSPs should be tax exempt as well.?However, it would be incumbent upon Tracy to prove to CRA that it is exempt, not the bank.

In Tracy’s case when she goes to withdraw the funds from her RRSP, the investment earnings are taxable income when withdrawn.?Only the original non-deductible contributions are non-taxable when withdrawn.

If an Indigenous person receives exempt income, in most cases, it would be better to paper file, rather than e-file as CRA requires an accompanying letter to prove the income withdrawn from a RRSP/RRIF is tax exempt.?

Registered Pension Plan Benefits

Under section 87 of the Indian Act, individuals earning exempt income are still allowed to contribute to a Registered Pension Plan if their employer participates in one. How much an individual can contribute of their exempt income is the same calculation as the RRSP calculation: 18% of their income earned to a maximum of $30,780 for 2023, plus any unused room from previous years.?The advantage of having the funds invested in a pension plan are that the funds will grow tax free each year.

When the individual retires, as per section 87 of the Indian Act, benefits received from a Registered Pension Plan (RPP) resulting from contributions on tax exempt employment income will also be tax exempt.?

Similarly any withdrawal from a RRSP/RRIF, T4As are issued by the financial institution that administers the pension plan. ?The individual will still be expected to file the actual slip, (but exclude the income from the tax return) indicating on it that the income is exempt under Section 87 of the Indian Act.?If available, they should also file an accompanying letter from the employer or pension plan custodian stating the origin of the pension plan contributions was from tax exempt earnings. If the pension provider that the employer uses is not familiar with the complex filing requirements then it can cause a significant amount of work and grief for the retired employee when they start to withdraw income from their pension plan.?

In Tracy’s case since she was an independent contractor she did not qualify to contribute to a registered pension plan.??If Tracy wanted to save some of her exempt income and have it grow, she was left with a couple of options:?invest in a Tax Free Savings Account (TFSA) or a non-registered account.?

TFSAs and Non-Registered Investments

TFSAs were started in 2009 and is one of the most underused savings vehicle to date.?Who can contribute to a TFSA is fairly straightforward:?the individual must be 18 years of age and have a valid social insurance number.?How much you can contribute to a TFSA is not an income test like the RRSP account.?If the individual was 18 in 2009, they would have the following room to contribute to a TFSA:

The annual TFSA dollar limit for the years 2009, 2010, 2011 and 2012 was $5,000.

The annual TFSA dollar limit for the years 2013 and?2014?was $5,500.

The annual TFSA dollar limit for?the year 2015?was $10,000.

The annual TFSA dollar limit for the year 2016 and 2017 was $5,500.

The annual TFSA dollar limit for the year 2018 was $5,500.

The annual TFSA dollar limit for the year 2019, 2020, 2021, and 2022 was $6,000.

The annual TFSA dollar limit for the 2023 was $6500.

?

If all these amounts are added together it would equal $88 000.?The name TFSA is also a bit of a misnomer; money that is deposited into a TFSA can be invested into many different types of investments: individual stocks; ETFs; mutual funds; structured notes; GICs; and savings accounts.?

Unlike RRSPs, you don’t receive a tax deduction when you invest in a TFSA, but also unlike RRSPs you are not taxed on amounts withdrawn from a TFSA. ?

In Tracy’s case, if she still wanted to grow her exempt income she could have invested the funds into a TFSA account and she would be able to add another $6000/each year (TFSA room is indexed to inflation and rounded to the nearest $500, so TFSA room will grow over time).?However, in Tracy’s case she had more than $88,000 she wanted to invest, after maxing out on her TFSA that only left a non-registered account to invest in.

Non-registered investments are basically any investments that are not sheltered inside a TFSA or RRSP/Pension accounts.?For investments in a non-registered account, Canadians are taxed every year on the interest and dividends and if something is sold for more than what you paid for it, then a capital gain tax is levied.?

In Tracy’s case if she were to invest the funds in any financial institution she would be taxed the same as any other individual.?However, if Tracy or any other status individual earns interest income (from a GIC, savings account, or other investment with defined returns) from a financial institution situated on a reserve, that income may be exempted.?Other types of investment income may also qualify to be tax exempt such as dividends received from a corporation based on a reserve.?CRA currently considers investment income that does not have defined earnings (mutual funds, investments in stocks, etc.) to be taxable income.??The original source of the investment income does not have to be exempt income.?It can be earned income that was originally taxed and the after tax income was invested.

Summary

To summarize, for Tracy’s situation it would best for her to avoid any contributions to RRSP accounts to avoid future penalties.?Tracy could also investigate the possibility of working with a financial group that is familiar with setting up pension plans for First Nations and Indigenous businesses; some plans can be opened for just one person.?If this is not possible, then Tracy should invest in TFSAs first and if she still has funds she wants to invest she should consider her overall tax situation before choosing her investments.

If you have any other questions I would be happy to help.