Should you file a tax return for a minor?
We have been filing tax returns for Rachel and Leah since they started working (Rachel worked at McDonald’s and both worked at Milestones). They don’t owe any tax so what is the benefit?
Well, their income is ‘earned income,’ so it is allowing them to generate RRSP contribution room. We haven’t opened up RRSPs for them, but we could. Unlike a TFSA there is no minimum age to open an RRSP. But in the future, this will benefit them. By being able to open and contribute to an RRSP, they will hopefully learn the benefits of saving and it may reduce their taxes in the process.
RRSP contribution room can only accumulate by having “earned income” documented with the Canada Revenue Agency (CRA).
Earned income commonly includes:
- Salary or wages from employment;
- Net business income carried on by a self-employed individual;
- Net rental income from real property;
- Royalties; and
- Net research
By filing a return, they will start to accumulate RRSP contribution room at the rate of 18% of earned income.
Here is an example of contributing to an RRSP and earning room at an early age.
Assume two schoolmates, Bob and Joe, each gets a summer job at age 13. They continue working and each earns $4,000 every summer. At age 22, they both get full-time jobs after graduating from university.
Bob’s parents file a tax return each year on Bob’s behalf while Joe’s parents do not. This extra effort made by Bob’s parents generates $6,480 [($4,000 x 18%) x 9 years = $6,480] of RRSP contribution room for Bob by the time he graduates from university. The tax rules allow for an indefinite carryforward of unused RRSP contribution room, so this RRSP contribution room accumulates for Bob from age 13.
Let’s assume that Bob’s marginal tax rate is 31%* when he starts working full time. Bob will be able to reduce his tax liability by approximately $2,008 ($6,480 x 31%) if he contributes the full amount of his carry forward room to his RRSP in his first year of employment. If Bob leaves the funds in his RRSP, by age 60, that extra $6,480 in Bob’s RRSP will grow to nearly $60,000 (assuming a growth rate of 6% per year).
Just by filing a tax return when younger, Bob will be able to save sooner and allow the savings to compound on a tax-deferred basis for a longer period of time, and potentially provide a larger nest egg at retirement.
The withdrawals Bob makes from the RRSP will eventually be taxable at his marginal tax rate at the time he makes the withdrawal. It may be possible for Bob to time his withdrawals so that the RRSP income he draws is taxed at a lower rate, like at retirement when he is earning less income and he is in a lower marginal tax bracket.
* The 31% tax rate is an estimate of the marginal tax rate for those with taxable income of approximately $85,000 in BC. The exact rate of tax savings will depend on the individual’s actual income for the year and their province of residence.
- Educational: If you involve your children in preparing their tax returns, they can begin to understand Canada’s tax system and may help them learn good financial management.
- Income splitting: If you own a business, consider hiring your children and paying them. There is no attribution on employment income earned by your child from your business. Keep in mind that the salary you pay them must be “reasonable” for the services they provide. Generally, if you are trying to determine what is considered reasonable, you should ask yourself what you would pay an unrelated individual to do the same work.
- Tax-deferred compounding: Going back to the example above, to take advantage of additional years of tax-deferred compounding, Bob could make the contributions to his RRSP annually ($4,000 x 18%= $720 per year) so that the funds are invested as soon as possible in his RRSP. He can also choose to claim the deduction when his income increases and he is subject to tax at higher rates in order to maximize the value of the RRSP deduction. The tax rules allow your unused RRSP contributions to be carried forward indefinitely. Please note that if you have over- contributed to your RRSP, you may be subject to penalties.
- Home Buyers Plan: If your children build up their RRSPs early, they could use the funds in the RRSP to take advantage of the Home Buyers Plan (HBP). The HBP allows your child to use up to $35,000 of their RRSP to purchase their first home.
Additional costs: You may incur additional tax advisor fees or have to dedicate additional time and resources in order to file a tax return for your child. Keep this cost in mind when determining whether it makes sense to use this strategy.
This is one of those parenting strategies that we will only know if it worked for in the future! But we think so. They already don’t like paying tax!!
|Tip: If you own a business, consider hiring your children and paying them a salary. There is no attribution on employment income earned by your child from your business.
Keep in mind that the salary you pay them must be “reasonable” for the services they provide.