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Think twice before deducting too many expenses on your return

Never fails. Every year, someone comes up with a new idea for a tax deduction.

"Tim, can I deduct the cost of my cosmetic surgery?" a woman asked me recently.

Now, normally it's not possible to claim those costs. But she was a self-employed exotic dancer -- so deducting her breast implants was an interesting concept.

"Hmm. As capital assets it might be possible to depreciate them over time," I contemplated aloud. "I'm just not sure which capital cost allowance class they fall into," I replied.

Regardless, it didn't make sense to claim the deduction for 2004 because it would have reduced her taxable income too much. That's right, it doesn't always make sense to deduct everything you can. Let me explain.

The deferral

When filing your tax return, the temptation will be to claim every possible deduction in order to minimize your taxes for 2004. Yet, it can make sense to defer claiming certain deductions until a future year in some cases.

You see, the amount of tax saved by a deduction equals the deduction amount multiplied by your marginal tax rate. For example, if you live in Ontario and made $50,000 in 2004, your marginal tax rate is 31.15 per cent, and a $10,000 tax deduction in 2004 will save you $3,115 in tax. The higher your marginal tax rate, the more tax you'll save from a deduction.

The key thresholds to remember are the first three federal tax brackets for 2004: $8,012, $35,000 and $70,000. As your taxable income crosses these thresholds, your marginal tax rate increases. If claiming a tax deduction brings your income below these thresholds, you may be better off deferring part of the deduction to a future year, if possible, where it means that the deduction can be applied against dollars of income in a higher tax bracket in the future.

The example

Consider Cary. He made $40,000 in 2004 and lives in Ontario. He managed to contribute $10,000 to his registered retirement savings plan for 2004, and plans to claim a deduction for this contribution on his 2004 tax return.

This will save Cary $2,711 in taxes in 2004.

It's important to realize that Cary will save more tax -- 31.15 per cent -- to the extent the deduction offsets income over $35,000. He'll save just 25.15 per cent on the deduction to the extent it offsets income under $35,000.

Cary would be better off if the full $10,000 deduction saved him tax at 31.15 per cent.

How can he accomplish this? By claiming $5,000 of the deduction in 2004 to bring his taxable income down to (but not below) $35,000, and deferring the balance of the deduction (the remaining $5,000) until next year to claim it against income over $35,000 (indexed to inflation) in 2005.

If Cary did this, he'd save $405 more in taxes than if he claimed the full $10,000 in 2004. This works out to a 14.94-per-cent increase in the taxes saved from the RRSP deduction.

The facts

Not all deductions can be deferred; most expenses must be claimed in the year they are incurred. But RRSP contributions and capital cost allowance can be deferred to a future year.

The deferral works best for those in the low- and middle-income tax brackets who might otherwise bring their taxable income below $8,012, $35,000 or $70,000 with deductions. It doesn't make sense to defer the deductions for long.

Tim Cestnick, FCA, CPA, CFP, TEP, is a tax specialist and author of Winning the Tax Game 2005 and The Tax Freedom Zone.

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