Tax planning must include strategies to deduct, defer and divide. The concept of effective tax planning can have a different meaning and emphasis depending upon your personal circumstances. Add in the fact that governments introduce new tax legislation every year and we begin to understand why Albert Einstein said, “The hardest thing to understand is income tax“.
Deduct, Defer and Divide
The three ‘D's' to investing are deduct, defer and divide. You must be able to understand all of these important functions in order to do effective tax planning.
- Deduct – A deduction is a claim to reduce your taxable income. A deduction will reduce your tax bill by an equal amount to your marginal tax rate. Some common deductions include:
- Pension plan contributions
- RRSP contributions
- Safety Deposit Box Fees
- Interest expense
- Union/professional dues
- Alimony/maintenance payments
- Employment expenses
- Moving expenses
- Professional fees
- Child care expenses
- Defer – A deferral strategy is to try to push having to pay tax now into future years. Deferring tax means you might eliminate the tax this year but you will eventually have to pay the tax down the road. Generally tax deferral has 2 advantages: (1) It is better to pay a dollar of tax tomorrow than it is to pay a dollar of tax today and (2) Tax deferral typically puts the control of when you have to pay the tax in the hands of the tax payer instead of in the hands of the Canada Custom Revenue Agency (CCRA).RRSPs, RESPs and various investment income strategies are the most common forms of tax deferral for the ‘average' Canadian.
- Divide – Often called income splitting, dividing taxes implies the ability to take an income and spread it among a number of different taxpayers. For example, it you have one person paying tax on $70,000 vs. having 2 people (say husband and wife) paying tax on $35,000 each, you would rather have the second scenario. Unfortunately, you cannot arbitrarily decide who is going to claim what amounts for income. There are, however, strategies to divide income within the rules of the CCRA:
- Spousal RRSPs help split income in retirement.
- Splitting CPP retirement benefits with your spouse.
- Pension splitting for retired couples.
- Investing non-RRSP savings in the lower income family members.
- Investing the child tax benefit in your children's name.
- Utilizing RESP contributions.
- Payment of wages to family members (through a business).
- Use of partnerships or corporations to earn business income.
- Utilizing either inter-vivo or testamentary trusts.
My two cents
I've always said that good tax planning far exceeds good investment planning. While taxation gets more and more complicated with every budget, the fact remains that you must understand the basic concepts of tax deductions, tax deferral and income splitting (dividing).
Sometimes tax planning will bring immediate benefits but often the benefits of tax planning take time to feel the rewards. Many people are scrambling to get their taxes done for the current year but it is probably too late to do any planning for the previous year.
The key foundation stones to effective planning include:
- Maintaining and retention of good records.
- Keeping informed and up to date.
- Knowing your needs and your goals.
- Assembling a team of good professional advisors.
I'll leave you with one final quote by Marc Denhez “Anyone who believes that Canada's only two official languages are English and French has never read the Income Tax Act.”
Obviously, if you are confused with the tax act and all the different rules then seek the help of a qualified professional to help you do some effective tax planning.