Income Tax 101

In the Financial Post 17 October 2015, there was a confusing article.  It outlined how a couple with a net worth of $10,000,000 and Income of  $215,000 Paid $0 in Tax.   I was unable to follow the numbers easily and I still don’t know the point.

For those who have asked me about it, I think this is what it says.

Net worth is made up of $5,000,000 of personal real estate.  $4,000,000 of unregistered investments $100,000 in a tax free savings account and $900,000 in RRSPS.

The income is composed of $150,000 of dividends, $10,000 of interest, $50,000 of realized capital gains and $4,000 of RRIF withdrawals. (only because they are untaxed)  They paid $40,000 in investment counsel fees, and donated $34,200 to charity.  They also received about $13,000 in Old Age Security but most of that was clawed back.

Why no tax?  These people are the one percent we hear about.  It is clearly wrong.  Well, maybe.

Notice how it works

  • $1,000,000 of the financial assets (RRSP + TFSA) generate no currently taxable income.
  • $5,000,000 of personal real estate earns nothing.  More likely costs a great deal.
  • $4,000,000 of financial assets earned $210,000.  Of that $150,000 was dividends, $50,000 was realized capital gains and $10,000 was interest.
  • The rest of their income was OAS and minimal RRIF withdrawals.

No tax does not imply no cost.  Most tax planners will tell you that you plan after tax, after costs,  effectively and let taxes be whatever they are.  In this case, things are a little more clear when you look at what is left.

Including OAS they received about $227,000.  The gave most of the OAS back to the government because their income was above the threshold.  That is tax no matter what you call it, so $0 of tax is  a little hyperbolic.  They paid $40,000 to their investment advisor.  They gave $34,200 to charity.  As a result, their in pocket money is in the low $140 thousands.

A further point to notice is that dividends tend to be tax efficient because the corporations themselves paid quite a bit of tax before they distributed to shareholders.  To get $150,000 in cash for the shareholders, the corporations likely paid about $65,000.  The whole picture will make a little more sense if we assume their dividends represent business income.  In that case, total income is $292,000 and the in hand remains at about $142,000.  They keep about half of the tax-reportable income.

og graphic 22 oct 15There are lessons to learn:

  1. What you pay in tax does not matter.  What you keep does.  If you have tax deductible expenses equal to your income you will never pay tax, but that defeats the purpose of having income.
  2. Income for tax purposes is a long way from income for economic purposes.  You live on economic income.  Tax preferences, tax costs and the confusion they bring, lead to weak decisions.  Understand that you can only spend cash and the cash cannot tell where it comes from.

Organize your life, your income and your assets to provide you with the things and experiences you want, security and something to share.  Minimize taxes but don’t give up many, or much of, the important things.  Taxes are an artificial concept and if you let that amount dominate your thinking you may end with a nice tax return but little value.

Nonetheless, Woody Allen points out, “Other than being shot at and missed, nothing beats a good tax return.”  Find an advisor that helps you generate an appropriate life plan with a good enough tax return.

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.

Contact: don@moneyfyi.com 

 

 

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2 Responses to Income Tax 101

  1. JodiDejong says:

    Thanks for clarifying that. It makes sense. My Dad always told me “you know your business is doing okay when you’ve got to pay tax”.

    • Thanks Jodie. Sometimes the part you keep matters. I knew farmers whose idea of profit for the year was how much the bank account went up. Didn’t matter if they bought the farm next door that year. If it went down that was a bad year. Your dad was right to apoint. People who manage a little more globaally than just income do great.

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