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.