Take Advantage of Fresh Start – Avoid Income Tax Traps

Posted in Debt Help
Posted by Ian Martin, CPA, CA, CIRP - LIT

avoid-income-tax-trapsIn the work I do, income taxes are a very popular topic of conversation.  Maybe “popular” is a poor choice of words.  People typically aren’t very happy to talk about taxes.  However, it’s an important part of the conversation if taxes are the reason for your financial difficulty.

Last week, I wrote about the powers of the Canada Revenue Agency (CRA) to collect income tax debts.  I also wrote about some of the special considerations with regard to income taxes and personal bankruptcy.  This week, I want to talk about a different aspect of income taxes.

If you’ve made the difficult decision to file for personal bankruptcy to deal with your debts, what comes next?  This is not an article about how bankruptcy works.  This is an article about not falling into the same tax traps that caused your financial difficulty in the first place.  I’ve completed a non-scientific study and want to review the three most common scenarios for causing income tax debt.  In no particular order…

#1 – Withdrawing Funds from RRSP

When you take money out of an RRSP, the bank is required to withhold a certain percentage for income tax.  For amounts up to and including $5,000, that amount is 10%.  The tricky part is that the actual amount of tax you should pay is probably much higher.  For many people, their actual tax rate is between 30% and 45%.

Consider a simple scenario.  You take $5,000 out of your RRSP and the bank withholds $500 for income tax.  You do your tax return the next spring and your actual tax rate is 45%, meaning you are required to pay $2,250 of tax on that $5,000 you withdrew.  Since only $500 has been paid, you owe another $1,750.  However, the money is gone because you used it to pay bills.  Suppose you’ve done this for two or three years.  With penalties and interest from the CRA, you could have a tax bill close to $10,000.

What this means is that using RRSP’s to get caught up on debts is potentially very costly.  If you’ve filed for bankruptcy and still have RRSP’s, try to keep in mind the real cost of using those funds.  You can have the bank withhold a higher portion than the minimum required by law.  Here’s some information from the CRA website about minimum withholding rates.

#2 – Part Time Job

The amount of tax that you are required to pay for any particular year is a complicated formula based on your total income for the year.  The more money you make, the more tax you pay.

Your employer is required to withhold amounts for your estimated taxes.  People can get into trouble when they have more than one job because each employer is estimating without knowing about the other job.  If you have a part-time job, that employer may withhold little or no income tax because they are not required to.

It’s really the same issue as taking money out of your RRSP.  You receive funds without having enough tax taken off.  By the time you figure out how much tax should be paid, the money is gone and all you’re left with is a tax bill and hard feelings.  If you are concerned about this kind of scenario, you can request that one or both employers take off more tax.  It might feel like a difficult decision is money is tight.  With income taxes, it’s pay now or pay later.  It’s easier to a little bit each pay cheque instead of coming up with a large payment at the end of the year.

#3 – Self Employed

There are many reasons why it can be great to be your own boss.  However, things haven’t gone as planned if you’ve had to meet with me.  Maybe you’ve lost a major contract.  Maybe you’ve had a significant injury or illness and have no benefits.  Maybe you need some help with bookkeeping.  The volume of government paperwork can be overwhelming.  Once you fall behind, it can feel as though it’s impossible to get caught up.

Legally, you are permitted to operate as a self-employed sole proprietor after you have filed for bankruptcy.  If you are going to do so, finding a bookkeeper to assist you with your paperwork is money well spent.  For others, it is easier to work as an employee.  It’s hard to fall behind on taxes if you are on somebody else’s payroll.


The biggest complication after filing for bankruptcy is that life will continue to throw you curveballs.  Filing for personal bankruptcy is about dealing with your past debt.  However, it is also an OPPORTUNITY FOR A FRESH START.  Filing for bankruptcy is a big decision.  Take advantage of that opportunity.