Once again, tax season has come and gone. Accountants are busy just like retailers are busy at Christmas time and investment advisors are busy at RRSP time. I thought I would take a moment to share some of my key tax tidbits:
- Tax Avoidance vs. Tax Evasion. The bottom line is tax avoidance is legal and tax evasion is illegal. Tax avoidance involves using tax loopholes in the Income Tax Act to minimize your tax bill. Tax evasion is knowingly falsifying statements or failure to disclose income sources.
- Plan ahead. Many people in the last couple of months seek advice to try to reduce their tax bill for the 2001 tax year. Unfortunately most of these people find that the options are few, because effective tax planning requires that you plan ahead.
- Tax Planning vs. Tax Preparation. Often people confuse the difference between tax planning and tax preparation.
Tax preparation is really the act of summarizing the historical events of a year, for example the year 2001. Tax planning is looking at the future and trying to develop both long term and short term strategies to minimize the tax bill. Anyone who understands taxation and the rules will also know that many tax planning strategies will require years of planning before you can reap the rewards. It is this time of the year that you should be thinking about the year ahead and longer.
- Know the rules. When I first started to make money I was fortunate to have been forced to do my own taxes. The real fortune was that I actually liked the area of taxes. Whether you like it or not, if you want to know more about how to save money in taxes, I would encourage you to do your own taxes. Even now, I still take the time to prepare and plan my taxes even though I have an accountant to do the filing. My accountant helps me to keep on track and make sure I am avoiding tax and not evading tax.
- Know your marginal tax rate. Your marginal tax rate is the amount of tax that you will pay on the next dollar of income. It will be the most important tax figure to know. You marginal tax rate depends on three things: (A) The level of income, (B) the province which you reside, and (C) the type of income you earn.
- Tax planning is more important than investment planning. Most people go to a financial or investment advisor in hopes of trying to earn better rates of return – say 1%, 2%, 3% or up to 5% over time. In my opinion, that is good value, but you are far better off starting the investment process by doing some good tax planning because this can help you to earn benefits in the range of 10%, 20% and up to 40%. Investment planning incorporated with your tax planning is invaluable!
- Deduct, Defer, Divide If you take a look at the tax tips that are very common around this time of year, they all refer to one of these three golden principles of tax planning.
- Look for tax deductions because they lower the income that is used to calculate your tax bill. The most common tax deduction available is the RRSP. Just like the four basic food groups are to healthy eating, RRSPs are to good tax and financial planning.
- Most often it is better to pay a dollar of tax later than it is to pay it today. While that is not always the case, deferral of tax can make a significant difference over time. Deferring investment income through tax efficient investments and mutual fund corporations is a good example of tax deferral strategies.
- If you can split income among different people, you will pay less tax than taking that same income under one individual taxpayer. Imagine if a family earns $60,000 per year. If one person makes all the family income, they will pay approximately $14,880 in tax. If that income were divided between two people equally, the tax bill would drop to $10,740.
- Be careful of rules of thumb. Rules of thumb are useful because they help us to communicate common tax and financial strategies to the majority of the people. However, rule of thumbs can also be dangerous. I'm always cautious in my weekly articles to apply strategies to “most” people (unfortunately, it is out of necessity). The reality is that “most” people are not everybody. You are not everybody. As a financial advisor, I meet people every day and the fact is everyone is unique and mass strategies cannot be applied to everyone universally.