moneyFYI
Financial Freedom Is Merely Organized Common Sense
Income Tax Effects
Recall that the money you earn goes to Now, Then, and Them. Now is your lifestyle, then is debt reduction and saving for the future, them is governments and other people who have a call on your income.
Recall further that a dollar is only good once. Once it is gone for one thing it is not available for anything else.
Tax management then can be a productive study. Take from them use in now or then
Ninety years ago John Maynard Keynes knew it and the facts have not changed since.
“The avoidance of taxes is the only intellectual pursuit that still carries any reward.”
Managing income taxes
What you do not send the government you can use to your own benefit.
The first and possibly the only important rules in managing your income taxes is
“Never manage the tax amount. Always manage what you keep”
How much you pay doesn’t really matter. It is counter-intuitive, but paying less often results in having less for yourself in the future. You can only use what you keep.
There are things to know
Marginal tax rate (MTR) is what you assess when making a tax decision. Marginal tax rate is the amount you would pay on one additional dollar of income or would save if you reduced your income $1. Average Tax Rate (ATR) is usually quite different. It is the amount of tax divided by the total income. Sometimes the resulting MTR and ATR rates you see are quite different. For example, in Ontario someone who earns a salary of $100,000 and has no other income has a marginal tax rate rate 0f 43.4% and an average tax rate of 24.2%. As with most planning things, you must study the boundary, the edge, or in this case the marginal rate.
Not every income type is taxed the same way. In Canada dividends per dollar received cost less tax than other forms of income like interest. The reason is there is a flow through of the tax the corporation paid before it paid the dividend. Only half of capital gains are included in income. Rental property and business income have many deductions unavailable to someone earning salary or interest.
Timing of when you pay the tax matters. At least as much as any other factor. The net present value of tax due in the future is less than the current MTR. Always manage net present value. Sometimes it is good to pay tax later because you get the value of the money or because your marginal rate might be lower in the future. Like after retirement. Sometimes you should pay more now and save even more later.
There are containers that have special rules. There are several deferred income plans for retirement. In Canada registered pension plans and registered retirement savings plans are the common ones. Both have limits (around 25,000 or 18% of income annually) on how much you can contribute and are reasonable about what you can invest the money in. There is also the ability to put money into a Tax Free Savings Account. Exactly as it seems. A tax free investment vehicles. The limit on capital contributed is $5,500 per year. Allocating capital to a container can help.
The general case of tax management
There are four tactics when addressing tax management:
- Deduct. Arrange your affairs so you have more permissible deductions from your income. In Canada the tax act is structured so with a few exceptions, you can deduct from businesss or property income any expense related to earning the income. From salary income you may deduct only from a specified list of permitted deductions. General wording gives you more advantage.
- Defer. A dollar paid later has a lower cost than a dollar paid now. Again subject to your particular circumstances.
- Divide. In a system with marginal rates that increase as income increase, two people splitting their income pay less than a single person with the same income. In Ontario the tax on $100,000 of salary split equally between two people would cost a little over $16,000 compared to $24,000 if just one received it. The government has many rules to limit your ability to do this.
- Change the income type. If you could change salary into business income you would likely be better off. The government knows that and there are rules to prevent it. Corporations have their own set of rates but generally there is an advantage to being incorporated as opposed ot being a sole proprietor in a business. Every case is different but it is easy to analyze.
How do tax shelters work?
Everybody loves a tax shelter. There are three general types. Any of them could work for you or maybe none would.
Type one relies on deductions.
You get a deduction for the capital you commit to the project but future income is taxable as earned. Some of these have turned out very well for the investors and some have wiped out all the capital. You must analyze them as you would a business. If you aren’t getting your money back with a profit, why do it at all. I know one person who paid no tax whatever for several years. Each year he bought tax deductions. Each year that went by added to the need because he had to shelter his personal income and he had to shelter the income being earned in older tax shelters. Eventually he decide it took half his time to run the shelters and he could work at what he knew best and pay 50% in tax and be no worse off. So he cashed out the whole structure, paid just under $4 million in taxes and went back to work at what he knew best.
These shelters are not easy to assess and for most people provide little benefit. The key factor is there maximum shelter value is in the first few years. After that, the shelter advantage wears out. Be sure you projects everal years into the future when deciding to invest this way.
Type two shelters defer income
These do not permit the deduction of capital but so long as the capital remains invested, the income is untaxed. When it is withdrawn the tax becomes due. Suppose you buy a 10 acre parcel of vacant land near town with the idea of waiting for the town to expand and then selling it to a developer. The property will increase in value each year hopefully, but no tax will be due until you sell. I have a client who has told me that when you buy by the acre and sell by the square foot you always make money.
Another interesting option is life insurance. The cash growing in a life insurance policy is not taxable to the owner of the policy. If withdrawn there is a calculation about how much is taxable based on several rules. That could be decades in the future. But that is not the key advantage. If you die with an income built up, no one pays tax on it. In this case you get the deferral advantage with the extinguish advantage tossed in. Worth a look.
Several decades ago, Canadian financial columnist Jonathan Chevreau made this point.
“In the constant war between taxpayer and tax collector, life insurance has become an unexpected ally of the oppressed”
Because interest rates were higher, it was more true then than now, but for many people, life insurance is still a useful advantage.
Type 2 shelters grow in value as time passes
Type 3 shelters permit the deduction of capital and the deferral of income.
These are generally created by governmental policy action and exist for retirement and other needs. Pension plans fit here. In Canada, a Registered Retirement Savings Plan provides an opportunity for those without a pension plan. Under these 18% of “earned income” as defined can be deposited to a maximum of $27,320 in 2020. The funds deposited may be invested in “qualifying investments” again defined, but while not unlimited, much like an investor would ordinarily choose. Beginning at the year following age 71, an income stream, legislated choices only, must be created and no further deposits are permitted.
At death the remaining amount may be rolled over to a spouse, or under strict limitations, to a child. When no rollover exists, the balance is taxable in the year of death. Type 3 shelters create more spendable income for a retired person than would taxable accumulations subject to some observations. Be cautious earning income that would have a tax preference if earned outside the plan. Be a little concerned about creating more income than you need after retirement. Sometimes people deduct at a low rate and pay later at a higher rate. Not too hard to project the balance.
One interesting aside, using a type 3 shelter means you will pay more tax than you saved. Usually a lot more.
Remember the prime directive.
Manage after tax spendable income. Don’t try to minimize the tax paid.
I help people understand and manage risk and other financial issues. To help them achieve and exceed their goals, I use tax efficiencies and design advantages. The result: more security, more efficient income, larger and more liquid estates.
Please be in touch if I can help you. don@moneyfyi.com 705-927-4770
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