Manage The Income You Keep Not Necessarily The Income You Earn

A long time ago,  in galaxy far far away, it was possible to make 10% or more with guarantees.  More with a balanced portfolio.  Here and now things are different.  Maybe?

We invest for a several purposes.  All of them, future spending, security, estate for children or charity rely or should rely on what money will buy and less on the number beside the dollar sign.  10% in a 40% tax world with inflation at 6% provides a real return of 0%.  Today 3% in a 40% tax world with inflation at 1.8% is identical.  0% real growth.

Except management fees have not changed and are a percentage of assets not income.  We must be much worse off!  Bad investment industry!

But, nothing is different.  If management fees are 2% and all of the other facts remain the same as above, there is a real return of -1.8% under each scenario.  You could work it out.

Yield minus fees minus tax minus inflation comes to real yield.  Fees don’t change anything so if we assume optimal yield for a particular investor’s profile, then managing inflation and managing tax become exciting opportunities.

Managing inflation is a seldom studied idea, but it can be done.  Most change involves organizational change.  Suppose I build a house without considering future energy costs.  These may inflate greatly in future.  Maybe by turning the house a bit to use the sun better I can save heating or air conditioning costs.  Maybe a ground-source heat pump.  Possibly supplemental solar.  Same thing with cars.  Own a fuel efficient vehicle, rent the big one the few times you need it in a year.  It is the same thing as a managing a business.  Replacing variable costs with fixed costs works in inflationary times.

Tax is manageable within limits.  The comments rely on Canadian tax law as it is today.  Hopefully the ideas are usable elsewhere, but no promises.

The obvious ones are the famous 3D’s.  Deduct, divide, and defer.

Many people miss deductions.  There are few for employment income but there are some.  There are more for investment income and many more for business income.  For business income it is the idea that you can deduct anything incurred to earn income with a few exceptions.  For employment income you can deduct certain things and nothing else.  Investment income is more like business income.  Be a little creative.

Divide is the ancient income splitting idea.  Two people with equal income pay less tax than a single person with the same total.  Learn the limits and the value and implement.  Sometimes the other is not a spouse or child.  Could be a corporation or a life insurance policy.  Learn more.

Defer means pay the tax later.  The win is that you earn something with money previously sent to the government.  Over long times that adds up to a substantial sum.  Retirement savings plans are an example.

There are three other guidelines and unfortunately they do not begin with D.

Use a different structure or container.

  • A tax free savings account for example is a container for investments that results in zero tax.  Despite the limits on capital employed, they are important.
  • A corporation is a more efficient way to earn business income.
  • Some trusts work better either for their rate structure or to assist in dividing income.

Change income type because the tax characteristics are better.

  • A capital gain is cheaper than interest income of the same amount.
  • Some dividends are better
  • A corporation is an easy way to change type.  Business income to you becomes business income to the corporation and salary, interest or dividends to you.

Have the lowest rate taxpayer pay the non-deductible expenses.

  • A corporation keeps 85% of its pretax income.  So it need $1,176 to pay a $1,000 expense.  A taxpayer in the 40% tax bracket needs $1,667 of income to pay the same bill.  Non-deductible things that are business related should be paid for by the corporation.  Life insurance premiums and golf club fees are the common ones.

The idea is manage the part you keep and the factors that affect that.

All of these points are generic.  Implementation will require specific professional help.  Use an accountant and or lawyer familiar with the concepts and your unique situation.  Do-It-Yourself tax plans are about as good an idea as a Do-It-Yourself root canal.


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