Thursday, February 24, 2011

Understanding Income Tax Instalments

Some Canadian taxpayers have to pay income tax by quarterly instalments. The rules surrounding these instalments are confusing and few people understand them well. It helps to go through the reasons why instalments exist and why the system works the way it does.

Why do income tax instalments exist?

Most people with jobs get income tax deducted from their paycheques. This means that the government gets paid throughout the year rather than getting a lump sum at the end of the year. It would be easy to make up impressive-sounding reasons for this but the real reason is that if we paid it all at the end of the year, too many people would blow all their income and the government wouldn’t get their money.

Some people make income through the year that doesn’t have any income tax deducted from it. A common case is a retiree with a large investment in bonds. The government doesn’t want to wait until the end of the year to get their tax money. So, these people have to pay quarterly instalments.

Why are the instalment rules so complicated?

Suppose that retiree Rhonda will owe \$4000 in taxes for the 2011 tax year. A nice, simple solution would be for Rhonda to pay \$1000 each quarter and owe nothing more at the end of the year. However, we have to be clairvoyant to get this right. What if Rhonda’s situation changes during 2011 and she ends up owing much more or less than \$4000?

The government’s solution is to base 2011 instalments on previous tax years on the assumption that Rhonda’s situation won’t change much. Of course this will be wrong in some cases, but the instalment amounts have to be based on something. Even basing the payments on 2010 won’t work because the first instalment is due March 15, but Rhonda doesn’t have to file her 2010 taxes until the end of April.

How does CRA calculate the instalment amounts?

The first two instalments of 2011 (March 15 and June 15) are calculated based on Rhonda’s 2009 taxes. Suppose that Rhonda owed \$6000 for the 2009 taxation year (not counting any 2009 instalments she may have made). Then CRA will ask Rhonda to pay \$1500 in each of the first two quarters of 2011.

For the last two instalments of 2011 (September 15 and December 15), CRA will base the amount on Rhonda’s 2010 taxes. Suppose that Rhonda owed \$4500 for the 2010 taxation year (not counting any 2010 instalments she may have made). CRA will then want the total of 2011 instalments to add up to \$4500. Rhonda has already paid a total of \$3000 in her first two 2011 instalments. So, CRA will ask for \$750 in each of the final two instalments of 2011. This system is a little bit complicated, but it makes some sense once you work through it.

Do I have to pay these instalment amounts?

The surprising answer is maybe not. You actually have three options:

1. Just pay the amounts CRA calculates for you.

2. Pay one-quarter of your 2010 tax owing (not counting any 2010 instalments paid) on each 2011 instalment. This requires that you figure out your 2010 taxes owing before the first instalment date (March 15). This is probably not too difficult.

3. Pay one-quarter of your 2011 tax owing on each instalment date. This obviously requires some clairvoyance.

The problem with options 2 and 3 is if you get the amount wrong and pay too little, CRA will hit you with interest and possibly penalties. However, these options are obviously much more attractive if your 2009 taxes owed were much higher than they were in 2010 and will be in 2011. One approach would be to guess your 2011 taxes owing and add a safety buffer.

Note that if you follow option 1 or 2 and the total of the instalments turns out to be too little to cover your 2011 taxes owing, you’re supposed to be safe from interest and penalties, but you still have to pay the excess owed at the end of the year. Note also that the rules for farming and fishing are different from what I’ve described here.

For more information on instalments, check out the CRA tax instalments page.

1. The CRA doesn't generally charge penalties unless the interest charges are over \$1000. The current interest rate is 5%.

Similarly, they don't even send a bill if the interest is less than \$25, so if cash flow is tight come December 15, you can be up to \$2000 light on that last instalment (if you file by March 15 the following year) and not pay any penalty. Had a few family members who over the years have pushed that last instalment to late January, without interest or penalty.

2. The Blunt Bean CounterFebruary 24, 2011 at 7:24 AM

Well done Michael, if you are looking for some extra income during March and April, I could use you :)

Yes, you may have to be clairvoyant to know what your 2011 tax payable will be; but most people have a fairly good grasp on that number. Where this is truly problematic is where someone had a large tax liability in the prior year based on a one time income event or no longer has an income source and assumes they will not have any income taxes other then employment income in 2011 and make no instalments.

Then one of three typical events occur to decimate the no tax liability assumptions (1) You are self employed and get large unexpected contract (2) You own real estate or other capital properties and get an unsolicited offer (3) you sell a stock(s) with large unrealized gains say because of a takeover or for market reasons.

If these events occur early in the year, you can at least mitigate the interest and penalty by making the correct instalments for the later quarters, but where these events happen later in the year, you will not be able to mitigate much of the interest and penalty and the penalty can be pretty hefty in that it is essentially (formula, but to keep it simple) 50% of the instalment interest (where your interest is greater then \$1,000 as noted by Potato).

3. @Potato: From all the accounts I've heard, CRA is not completely consistent in how interest and penalties are applied. In general, though, the interest/penalty is in proportion to the shortfall. Taxpayers are generally not punished out of proportion to the amount their instalment payments are short.

@Mark: Thanks for the kind words and the "offer" :-) I understand parts of tax law well (mostly the parts that have affected me), but other parts not well at all.

A couple of times I've been in the position of trying to guess my income for the year to avoid very high instalment requests from CRA. Fortunately, I got the numbers close to right, but I can certainly see circumstances where I could have been very wrong.

4. I just wrapped up my 2nd year of self employment and have never made an installment payment, so this article had me sweating over interest and penalties. Then I found this on the CRA site:

We charge instalment interest if all of the following conditions apply:

we send you an instalment reminder in 2011 that shows an amount to pay;
you are required to make instalment payments in 2011 (see Who has to pay tax by instalments); and
you did not make instalment payments, or you made payments that were late or less than the required amount.

I've never received an instalment reminder, so I guess I'll stop sweating. I expect it to come someday (and I have funds set aside for that day), but I'll enjoy my tax holiday while it lasts.

Dan.

5. @Dan: If you owed more than \$3000 on your 2009 and 2010 taxes, you should expect to be asked to pay instalments at some point.

6. Whenever CRA send me a notice regarding installments payable the current year, I simply write them a note explaining that my "income" is variable from year to year and that their installments do not reflect my current income level. I end up paying the following year - in the meanwhile making use of the sums that would have been paid in installments, but making sure that money is available when the taxes are due. I rather pay later than earlier.

7. If 2010 is the first year I've had a large tax bill (I won't be able to file until April because I'm out of the country) and I will have an even larger tax bill (\$100k?) for 2011 will I likely escape penalties for 2010? Will I be expected to forwArd 25% of my 2010 tax bill to cover the first instalment of 2011 at the same time I submit my tax bill for 2010?

8. @Poedin: If you've never been hit with interest or penalties, my guess is that you've always paid amounts that are within the rules by one of the 3 allowable methods. Generally, CRA does not demand instalment payments. They just charge interest and penalties if you should have made instalments.

@Cannon-fodder: Without knowing more about your situation, I can't promise anything, but I can tell you my experience. In the first year I owed a large sum, I was not charged interest or penalties. I wasn't even asked for instalment payments the next year. However, based on the rules as written, it seems that CRA could have asked for instalment payments starting in the 3rd quarter of the next year.

9. I had to pay about \$3,500 for my 2009 taxes and for 2010 I projected I would be paying more than that.

I didn't want to put myself in a position where I had to pay by installments so although I was not required to make installment payments I made one in December 2010.

Are you able to tell me if this will ensure that I am not require to make installment payments in 2011.

After the installment payment in December I will only owe an additional \$300 or so.

Any feedback would be appreciated.

Thanks!!

10. @No Debt Guy: When computing instalment payment amounts, CRA does not take into account past instalment payments. This makes sense if you think about it. However, I don't know for certain what triggers the demand for instalments. It doesn't make sense that your instalment payment would prevent CRA from asking for instalments for 2011 or beyond, but things don't have to make sense.

11. Is it possible to reassign installments made in 2011 to 2010? We have a huge tax bill for last year (long story, was kept out of the loop, now doing damage control), and we're starting a business this year (i.e. likely operating at a loss for the first few quarters). The installments paid in 2011 are just going to sit there.

12. @Buddy: Not being a tax expert, I can only tell you about my own experience. In all my dealings with CRA, I've just had a balance that CRA adjusts each time I make a payment. So, I've never had an outstanding debt from one year and an outstanding credit from another year because they automatically cancel out.

However, this doesn't apply between separate people or companies. In some cases it's possible to assign a surplus from one account against a deficit in another. If this is your situation, you should probably contact CRA to see what can be done. It's hard to say much more than this because I don't know your situation and I'm not a tax expert.