Taxes are the biggest line item in our personal budgets. It makes some sense to learn how to address them.
From the government’s point of view there are three general rules of the game:
- Taxpayers cannot win
- Taxpayers cannot break even
- Taxpayers cannot refuse to play.
If you play the game without thinking, these rules are absolute. Most tax practitioners will tell you that there is some flexibility in rule 3)
Governments try to accomplish two things with tax laws. Raise the cash they need to carry out their perceived mandate and minimize the push-back from the people. Income tax is the easiest to work with. Other taxes like commodity taxes, duties, service charges and such have their own rules.
There are cheap and easy ways to raise the money, but you manage push-back with favors, punishment of high income earners, and preferences. Minimizing push-back creates complexity and for tax managers, complexity is good.
- Consider the progressive tax table. The idea that rich people can afford more appeals to most people and there are too few rich people to make a difference at the ballot box. You can adjust rule 3) by income splitting. Two people will pay less tax than would one earning the same amount. Business income can shift to a corporation and so long as it stays there the tax is much lower on each dollar of income.
- Consider income types. Types like rental income or business income have more allowed deductions than do salaries. Some investments provide super-deductions.
- Consider preferences. Capital gains are only half taxable. Tax previously paid by a corporation on its income reduces your tax on the dividends you receive.
- Consider timing. Money you pay in the future is worth less today. You could invest it until payment is due and accumulate interest. If I invest $1,000 today at 4%, I will have $1,217 in five years. So my $1,217 bill due in five years is worth just $1,000 today. If I can put it off for 30 years under the same conditions, my $1,000 today will pay $3,243 then. There are several ways to defer tax. Certain mutual funds are tax sensitive. Capital gains are not taxed until sale. Life insurance provides shelter from tax on accumulating income. Retirement plans defer the tax due today to some day in the future when you spend it.
- Consider extinguishing the tax. In Canada, you can avoid tax on accumulating investment income using a Tax Free Saving Account. There is a limitation on capital, but no tax on the income. Your principle residence creates no tax due when sold at a profit. Life insurance extinguishes tax due on accumulated earnings when you die.
Divide, deduct, defer are the headlines for your tax plan. Extinguishment is nice, but limited or without a death not always possible. Most people will not die to suit their tax plan.
There are limits to how much any person can do, but every little bit helps.
Learn a little about the process. Know that marginal tax rate is the rate you pay on the next dollar of income. Know that average rate is nearly useless for planning purposes. Know that effective rate is the time adjusted marginal rate.
Effective rate matters because taxes compound. If I pay 50% tax on a 6% income stream for 40 years, a $1,000 investment will grow to be $3,262. If I paid the tax at the end, $5,643 for me. If I paid no tax $10,286. By paying annually my effective rate of loss is 75.6% of the potential income.
No one should accumulate money without understanding a little about taxation. Seek help. The rules are dense and not easy to find.
Don Shaughnessy arranges life insurance for people who understand the value of a life insured estate. He can be reached at The Protectors Group, a large insurance, employee benefits, and investment agency in Peterborough, Ontario. In previous careers, he has been a partner in a large international public accounting firm, CEO of a software start-up, a partner in an energy management system importer, and briefly in the restaurant business.
Please be in touch if I can help you. firstname.lastname@example.org 866-285-7772