Very often we begin financial planning from a net position, dealing with what we have left after the tax man takes his pound of flesh. We should be structuring our affairs to keep the tax bite to a minimum.
A very long time ago I suffered through a full-year, six-credit-hour course in income tax. I learned two things, the first of which was the four Ds of tax planning. Work out how you can use these four approaches and you should be able to avoid as much tax as is legally feasible.
The first D is “deduct”. Take advantage of all deductions to which you are entitled in order to reduce your taxable income. Self-employment, or even a home-based business on the side of your primary employment income, may give you the opportunity to deduct some of your residence, automobile and other expenses.
Of course your business must earn income to take advantage of such deductions, which are incurred to earn that income. The expenses must relate to the income; for example one room of a six-room house being dedicated as your “office” would allow you to deduct one sixth of your household expenses. A more recent variation of deductions is tax credits. These are taken after tax is calculated but the effect is similar, a small reduction on the cheque written to the receiver general.
The second D is “divide”. For retirees, this D is less important since pension income splitting has been allowed. The idea is to divide family income where you can so that each person is in a lower tax bracket and the sum of taxes paid is a little less. Again, a small business can “hire” a spouse and older children which is then expensed to the business. But be sure it is legitimate. Our teen-aged children used to clean the office on the weekend; they thought it was “allowance” but for us it was a legitimate business expense.
Third, one should “defer” paying taxes as long as possible. The most common example is the Registered Retirement Savings Plans where a portion of income is put into the RRSP, earns tax-free returns and is only taxed when it is withdrawn. The idea is that in retirement one will be in a lower tax bracket and so pay less tax. But even if one is still at the highest marginal tax rate at age 71 when withdrawals must start, it is still advantageous to have deferred paying the taxes on this income as long as possible.
The fourth D of tax planning is “dividend”. Some forms of income, such as dividends, are taxed at more favourable rates. The taxing of dividends is complex, involving issues of eligibility, gross-up and tax credits. Capital gains are simpler, tax is only payable when the gain is realized, and at that the gain is taxed at half the rate, so that a $100,000 capital gain is treated as only $50,000 in taxable income.
The main implication of this D is in how an individual organizes their overall portfolio. For example, the taxpayer would keep fixed income investments, which generate fully taxable interest income, in tax shelters like RRSPs and Tax Free Savings Accounts. Equity investments which produce tax-advantaged dividends and capital gains would be held in non-registered accounts.
I said earlier I had learned two things in my tax course. What was the other? I learned that if I ever have to complete anything more complicated than the old T1 Short tax form, I should take my return to a professional because income tax is so complicated that it takes a full time professional to stay on top of it.
Even if your situation is not too complex, the professionals now have tax software that takes you through all the steps to help be sure you do not miss any deductions.
Next month we will look at allocating some of your income to savings for investments. The objective of financial planning is to grow wealthy enough we no longer need to work or use insurance for our family’s risks or to work, as our money will work for us.
Fred Petrie, MLI Insurance, provides financial planning for families and independent businesses. He can be reached at 204-885-3438 or email email@example.com.