(As published in Lifestyles55+ April 2013)
To re-cap, the first step was making sure income exceeds expenditures, through budgeting our cash flows and tracking our actual performance. The second step was dealing with the first “certainty of life”, namely, Death, as in managing the risks associated with premature death, long term disability or critical illness, all very real risks in financial planning for our family’s security and our eventual independence. Now we turn to the other certainty of life – Taxes.
Very often we begin financial planning from a net position, of what we have left after the tax man takes his pound of flesh. This column is about structuring our affairs to the extent we can to “avoid” taxes. Please note that avoiding taxes is legal, we are not counselling tax evasion which can result in another risk to your future income stream if you are in jail!
A very long time ago I suffered through a full year six credit hour course in income tax. I learned two things. The first was the four D’s of tax planning. Work out how you can use these four approaches and you should 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 and automobile and other expenses. Of course your business must earn income to take advantage of such deductions incurred to earn that income, and 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 1/6th 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 little smaller 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 so that 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 Registered Retirement Savings Plans where a portion of income is put away, 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”. This simply refers to some forms of income, such as dividends, are taxed at more favourable rates. The taxing of dividends is complex, with issues of eligibility, gross-up and tax credits. Capital gains are simpler as they are only taxed when realized (i.e. deferred), and then are only half taxed, so that a $100,000 capital gain will only be $50,000 taxable income.
The main implication of this D is in how you organize your overall portfolio. For example, you would keep your fixed income investments, which generate fully taxable interest income, in tax shelters like RRSPs and TFSAs. Your equity investments which produce tax advantaged dividends and capital gains would be held in non-registered accounts.
You may recall that I said I had learned two things in my tax course, what was the other? I learned that if I ever have anything more complicated than the old T1 Short, 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 all. And even if your situation is not too complex, we now have the tax software that takes you through all the steps to help be sure you do not miss any deductions.
Next month we will finally turn to what you have been waiting for, allocating some of your income to savings for investments. The objective of financial planning is to grow wealthy enough we no longer need insurance for our family’s risks or to work, as our money will work for us.