Wednesday, 31 May 2017

What to do with Windfall Income

Dealing with Unexpected Income


You're going along, living your life, and then all of sudden something happens, and you find yourself with extra income you weren't prepared for. This can occur for a variety of reasons, some great (bonus from work) some horrible (a loved one passing away). Whatever it is though, you should take the time to plan your best course of action and know any tax consequences that might be coming your way.

Inheritance
Let's get the hardest one out of the way first. If you are getting an inheritance it means that someone close to you has passed away, so not only are you dealing with grief but now you need to figure out what to do with this money. In Canada, there is no inheritance tax. This means that if you are a beneficiary of an estate, you won't have to pay tax on the amount you receive. The estate actually settles up the tax bill before disbursements are made to the beneficiaries.

There are certain exemptions when it comes to how an estate is taxed. Usually, assets are deemed to have been sold at fair market value on the date of death. Non-registered assets are taxed as capital gains (only 50% of the gain is taxable), and registered assets (i.e.,. RRSP's) are taxed as income. Registered assets can, however, be passed on to an eligible beneficiary (spouse or common-law partner, underage child or grandchild, or financially dependent mentally or physically disabled child or grandchild). In this case, the tax would be deferred until that beneficiary begins making withdrawals from the registered account.

While not exactly an inheritance, a life insurance payout is also something that often goes hand in hand. One of the big perks about life insurance is that the payouts aren't taxable, and it is kept separate from the estate. An important factor to note is that there can be tax consequences for certain types of life insurance. Term insurance is the most common and won't cause you any problems tax-wise...you pay your premiums, and then your beneficiary gets a payout if you die within the term. Permanent insurance (whole or universal life) has an investment component and also gives you an option to cash out your insurance early (aka. before death). If you do that, the tax can become an issue as you will be taxed on the growth. Not such an issue as a beneficiary, but something to keep in mind before cashing out a policy.

Lottery Winnings
Onto happier windfalls and living the dream! First off, let's just write off any sort of expectation that you are going to win the lottery; it's not going to happen and you should 100% not bank on that to fund your retirement. I'm such a downer hey? Somebody has to win though, so in the unlikely chance it's you, here's what you need to know. Unlike in most states in the US, you don't have to pay tax on lottery winnings in Canada. Go ahead and bask in the lotto glory ;)


The no-tax rule doesn't only apply to cold hard cash winnings, it extends to material prizes such as houses or cars. There is one small caveat to this though. If you hold onto the prize for a bit and it increases in value then you will have to capital gains tax on 50% of that growth. There's no rule that you need to live in the dream home for a fixed period before you can sell it to avoid tax.

Work Bonus
If you get a bonus from your employer, it will be taxed as employment income. Makes sense, but it's not always that simple. Depending on the type of bonus and how your employer handles it, there may or may not be tax taken off before you get the cheque. If there's no tax taken off, then you might be in for a rude surprise when you file your taxes the following year.

This exact situation happened to me this year. I got a Christmas bonus that wasn't taxed (not unusual), but it was, of course, included on my T4. My taxes were super simple this year (just a T4 and RRSP contributions), and I could not figure out why I was owing instead of getting a refund. Oh right...Christmas bonus! Keep this in mind if you get a sizable (untaxed) bonus from work and maybe set some aside to cover your tax bill.

Investment Returns
Maybe you hit the investment jackpot and had a huge return on a stock pick. Now you're thinking you should cash out and lock down the win before you lose anything. Certainly not a bad idea, but keep the taxes in mind. If the investment is sitting in an RRSP or TFSA, then you're in the clear and won't have to pay tax at all (TFSA) or until you withdraw the funds (RRSP). However, if you're dealing with a non-registered account, then you will be looking at a capital gains tax on 50% of the growth.

An example:
Initial Investment: $1,000
Value at Time of Sale: $10,000
Growth: $9,000
Tax Bill (assuming 30% marginal tax rate): $1,350
Your Net Profit: $7,650

You're still up $7,650, but it's amazing how often people forget about that when tax season comes around and they owe $1,350 to CRA. 

Home Sale
The only time you are going to get a big tax bill if you sell a property is if it's not your principal residence. Selling the home that you have lived in for the entire time you owned it means you are exempt from paying tax on it. Notice the keyword 'entire' in that last sentence? If you bought a home, lived in it, then moved and rented it out for a bit, then went back to living in it...you are technically responsible for paying tax on any gain in the value of the house that occurred when it wasn't your principal residence. Complicated, I know! Some people think they can bypass this rule by moving into the property for a period of time to get the exemption, but the government has been cracking down on this and have put new reporting rules in place. 

A less complicated situation is if you own a property (rental property, cabin, etc.) that has never been your principal residence. When you sell this type of property you are responsible for paying capital gains tax on 50% of the growth (just like with your investments). 

Retiring Allowance / Severance
You may receive a payout from your company if you retire or if you are let go from your position. That payment is taxable and will be taxed by your employer based on how much it is. You can potentially have the tax waived by transferring all or a portion of your payout to your RRSP account. To be eligible for this sheltering one of the following two options need to apply:
  • $2,000 can be transferred for each year or part of the year you worked for that employer before 1996 (or $1,500 per year if before 1989). 
  • You have RRSP contribution room available. 
If one or both applies then the payout will be transferred to your RRSP with no tax taken off, but you won't get the claim it as a contribution the following year. Any amount that does not fit into one of those exemptions will be taxed. 

Cash Gifts
Canada has no gifting tax so if you receive cold hard cash from a very generous relative for your birthday or as a wedding present you don't have to claim it as income. One thing you can't do is give money to your spouse who is in a lower tax bracket for preferential tax treatment. Obviously, this is out of the scope of the 'gifting' I'm talking about, but it's amazing what people will do to not pay taxes. For those who are interested, you can lend money to your spouse, but it does need to be done as a loan and interest needs to be charged (and paid) annually. The government currently has this 'prescribed interest rate' set at 1%.

Dealing with Unexpected Income

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