Everyone likes to minimize their tax payable. People, accountants in particular, like to help them do so. People could do better if they knew a little more about the opportunity.
This is not a good do-it-yourself project. Tax law is complex and changes regularly. The following is intended to form a basis for discussion with professionals aware of both the law and the specifics of your personal situation.
Here is the 2 minute lesson overview:
There are three tax rates that matter. Average rate, marginal rate and effective rate. You use these to think about opportunities.
Average rate is, as it implies, the average percentage rate you pay on all your income. Earn $100,000 and pay $26,000 gives you an average rate of 26%. Misleading at best and the fodder for many spurious political arguments. It lumps together all sorts of different kinds of income and ignores other factors that matter, like corporations or trusts in the income stream.
Marginal rate is the rate you pay on the next dollar you add to your return. This one permits some management. Timing matters. Income taxed this year might be cheaper than next year, so trigger it early. You can manage some things relating to the next dollar. All decisions tend to be made best at the margin of the facts, so understand the difference between average and marginal.
Effective rate is more subtle still. It includes time, availability of deductions, tax rates on certain kinds of income and less common things like future residence. This is the one where the biggest gains live.
Time is a profound factor in the effective rate. The theme for accountants is a dollar deferred is a dollar saved. That is not quite true, but it is important. Just like interest, tax costs compound over time. For example suppose someone invests $100,000 at 7%, all taxable at 40% marginal rates. In 40 years they will have $518,500. Alternatively they invest at 7% but pay all the taxes due at the end of 40 years. The tax bill will be $559,000 then, and there will be $938,500 left. The effective tax rate for the second condition is 17.8%. Even if they had to pay 50% at the end, the effective rate is just just 23%.
Some income forms allow more deductions than others. Salaries and interest nearly none, business and rentals are more liberal.
Some income has a preferential rate. Capital gains are only half taxable. Dividends look that way, but personal circumstances matter. Be careful with this one.
Income splitting matters. Two taxpayers in Ontario, with $50,000 each of income pay around $7,000 less tax than one taxpayer with $100,000.
The cost of paying expenses that are not deductible can be minimized if they qualify as business related and are in a corporation. Life insurance is one example. A person with a marginal tax rate of 40% must earn $8,333 pretax to have enough to pay a $5,000 premium. Their business corporation must earn just $5,900 to do the same thing.
Good tax management requires that you manage the long term effective rate and you do so by deferring tax, dividing income or taking advantage of deductions or special credits. Lastly look for a way to change the income type.
It is possible to make only minor changes in the way you organize your affairs and end up with meaningful advantages.
Don Shaughnessy is a retired partner in an international public accounting firm and is now with The Protectors Group, a large personal insurance, employee benefits and investment agency in Peterborough Ontario.
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