I forgot to mention in my last column that November is Financial Literacy Month! As this may be on the stands a week or two before the end of November, consider yourself told. But as a regular reader you are already looking after your financial intelligence.
For this month, I am keeping to the spirit of the season with my title. The last few columns have talked about making money through consistent application of balance and diversification. In my seminar about managing money, I start by talking about first making some money, then managing your money to keep your cash flow positive. But then you need to proactively manage the risks to your money. However you invest, there will be a multitude of parties trying to stick their hands in your pockets. But you have learned to budget and set priorities so you have developed resistance to the siren sales pitches that tout the latest that you just must have! And I have repeatedly written about the companies and advisers who complicate finance and ask you to trust them, with excessive fees and shell games. You might be your own Grinch by keeping your money in bank GICs (or under the mattress, equally useless) where you watch your capital bleed away. But you have read THE END OF WORK and now understand the financial business and the trade-offs and risks so that you can invest with confidence, while sniffing out the con games.
This month is about the biggest Grinch of all, who takes a large portion of your investment returns, delaying you in reaching the destination of financial independence – the Canada Revenue Agency. THE END OF WORK devotes its last chapter to Tax Planning.
It’s your money, but most of us are willing to pay our share of public services. However, politicians have an insatiable appetite for our money. Provincial and municipal politicians and empire building bureaucrats are no better than CRA. And it keeps getting more complex because politicians do not want us to see when they are picking our pockets. Public finance is no better than a shell game, but that is the subject for another book.
We do need to pay the legal taxes. There is a big difference between tax evasion and tax avoidance. The first can lead to a jail term. The second is legal and keeps more cash for you to invest in your future. Tax lawyers and accountants, not much different from financial advisors, will milk you for fees to advise you how to avoid paying tax. While you may need these professionals to keep you out of jail, you can be more effective if you understand the principles. A long time ago I took a full year, six credit hour course in income tax. I hated the subject and got the bare C+ needed to pass. But I did learn two things. One was that if your situation was ever too complicated for a T1 Short (or Quick Tax Basic), then get a professional, because it is a full time job to stay on top of all that stuff.
The second thing I learned was the four D’s of tax planning. The first D is to DEFER paying taxes as long as you legally can. Many people are happy to get a tax refund in April. They should not be. A refund simply means that you have given the government more of your money than required and they do not pay you interest. The idea of deferment is to organize your affairs to pay as little as possible until they ask you for it by an assessment. And do not submit your tax return (or at least post-date your cheque) till the 30th of April. Different sources of income can be deferred better than others; there are many breaks for “small business”. The best known tax deferment is by having investments in RRSPs. You can defer the tax and thereby invest more pre-tax dollars and the earnings are also sheltered. But an RRSP only defers the payment of the taxes due. You only avoid paying some tax when taking it out in a lower tax bracket, after retiring.
The second D is to DEDUCT. On salary income, your TD1 form lets you deduct your personal exemption. Be sure to deduct any others you can claim, like a dependent spouse and children. On self-employed or corporate income, the scope is broader on what you can justify as expenses that are legitimate to deduct because they relate to making that income. Having a small home based business on the side that generates some of your income from self-employment allows you to deduct some of your household and transportation costs that you may have incurred anyway. Any deductions you do not take is money left on the government table.
The third D is to DIVIDE your income to get a lower tax rate. The main example is between spouses where both can be shareholders in a family business, each taking some income in tax-preferred dividends. If we just had a flat tax at the same rate for individuals, families and corporations, on all sources of income, life would be a lot simpler! But think of all the accountants, lawyers and financial advice book writers who would be out of a job ….
Some tax experts stop at three D’s but the fourth, DIVIDEND, is an example of taking advantage of legal preferential tax treatment. The idea is that dividends have already been taxed at the corporate level before the cash flows out to shareholders as dividends, so some allowance is made to reduce double taxing the same income. The tax treatment of dividends is quite complicated. Your job in being tax literate is to ensure your tax professional helps you take advantage of structuring some income as dividends to reduce your taxes payable. Capital gains also receive preferential tax treatment so I include them in this D. The theory is there is higher risk in making this income so it should not be taxed as heavily as more secure income like interest and salaries.
The government has provided one legal means of tax avoidance. A Tax Free Savings Account allows money already taxed to then earn income without further tax on the investment income. This makes it an excellent vehicle for non-tax-preferred income, like fixed income assets. Insurance also has tax benefits; a Universal Life investment can grow tax-sheltered much like a TFSA.
THE END OF WORK chapter also talks about integrating the use of the four D’s and planning how to get your money out of tax deferment with as little tax as possible, especially to avoid the big tax hit on death. But I am already 300 words over my allowed column length.