A source deduction letter can help clients receive tax credits early and maintain their cash flow throughout the year.
Daryl Chan is a devoted member of his church. He attends services every week with his family and serves on the church board. Like many in his congregation, he believes in tithing and makes sure he gives the church an annual donation of $12,000, which represents 10% of his gross earnings.
While Daryl’s generosity is rooted in his devotion to his faith and a deep belief in supporting his church, he also enjoys con-siderable attendant tax advantages. The federal and provincial governments together permit taxpayers to claim tax credits on charitable donations totalling up to 75% of annual net income. As Daryl’s church is a registered charity, his $12,000 tithe produces a direct reduction in taxes of $5,181.
Not every Canadian is as philanthropic as Daryl. Statistics Canada reports that in 2001 the average Canadian taxpayer donated only $251.95 to recognized charities. Of the one in four Canadians who actually made donations averaging $998.66 that year, the median donation was still only $200. Not surprisingly, for most Canadians the resulting deduction is similarly modest, and at least half of the donating public never even access the higher tax credit rate over $200.
But in Daryl’s case and others like him, the tax relief is considerable, especially when he includes another $19,300 in deductions for the carrying charges on his investment loan, his RRSP contribution, and his accounting and financial planning fees.
But the benefit is long deferred. According to standard CCRA rules, his employer must deduct income tax at source based on his $114,000 net income (his $120,000 annual gross income, less the $6,000 withheld each year for his money purchase pension). Daryl has to wait until the spring of the following year to file his return and then receive the $13,366 tax refund generated by the tax credits and deductions he has. This means, on a biweekly basis, Daryl is deferring a refund of $514 in tax; that’s $1,114 per month! This cash, if freed up from taxation, goes a long way to offset his monthly RRSP contribution of $625, investment loan of $833 and $1,000 tithe.
But there is some good news for Daryl’s cash flow. He can apply to reduce his income tax at source for the charitable donation by completing a T1213 “Request to Reduce Tax Deductions at Source for Year(s) ___” and submitting it to the client services division of his local tax services office. He will have to include documentation outlining the donations he makes to his church as well as other items that reduce his taxable income, such as any non-payroll RRSP contributions or deductible interest. If these items are approved, CCRA will send a letter of authority for the year (sometimes called a “source deduction letter”) to Daryl’s employer permitting a biweekly reduction of $514 in the income taxes with-held. As this is an annual authority, Daryl must remember to file the T1213 each year to re-obtain permission for his employer to reduce tax withheld.
According to the payroll deductions section of CCRA’s T4001 “Employers Guide,” a letter of authority is not required by the employer to reduce tax at source if the employer withholds any of the following from remuneration:
- employees’ contributions to a registered pension plan (RPP)
- union dues
- contributions to a retirement compensation agreement (RCA)
- deductible support payments
- contributions to an RRSP, provided the employer has reasonable grounds to believe that the
contribution can be deducted by the employee in the year.
For further information see the “Step-by-step calculation of tax deductions” in Part A of the “Payroll Deductions Tables” (T4032).
The use of source deduction letters to provide an immediate income tax deduction can be useful not only for people who tithe like Daryl, but also for anyone regularly maximizing their non-employer RRSP contribution, making a large contribution early in the year, those who are making a large RRSP “catch up” contribution, or those with significant carrying charges, anticipated rental losses, legal expenses incurred to collect child support and/or allowable business investment losses. CCRA will require reasonable proof or substantiation of these activities. Once received, they are much more likely to approve a reduction in source deductions if the taxpayer is not and has not previously been in arrears with them, or if they have a history of having significant non-taxed income from dividends, interest, capital gains or self-employment for which a balance would be owed in April. Keep in mind that CCRA approval can take six or more weeks. Some taxpayers try to apply in November or December of the prior year in order to receive their approval early in the new year. Whether discussed late in the year or early in the new year, the topic can dovetail well with year-end tax planning or the RRSP conversation.
This strategy will not be worth the effort for clients who do not have large deductions or credits.
In Daryl’s case, thanks to the immediate $13,366 improvement to his annual cash flow, he is better able to afford tithing and fund his RRSP and investment loan from cash flow. The source deduction letter is a critical component to his financial plan allowing him to meet his long-term goals for retirement and education.