I hope the Canada Revenue Agency doesn’t come after me for writing this post 😛 If too many people read this article then our government will never have a balanced budget lol. Since it’s that time of year again the topic I’d like to discuss today is income tax, and how rich people are able to dramatically reduce their taxable incomes because they understand that tax brackets are a moving target, and we all have the ability to manipulate our income tax rates as we see fit 😎
Let’s look at an example below. The following chart shows the income tax rates for B.C. Canada. There are only 6 cells we need to be aware of for the purpose of this article, which I’ve highlighted in yellow.
Let’s say a hypothetical person named Tyler works full time at a retail bank branch and makes $43K a year there. Tyler also bartends a few nights a week. He has a small rental property, and some dividend paying stocks in a margin account. And finally Tyler has a small pasture of alfalfa in the boonies that he operates as a small business and is generating revenue via renting it to cattle ranchers.
Here’s a summary of all his annual incomes.
- Bank employment T4: $43K
- Bartending T4: $10K
- Rental unit: $12K
- Dividends T5: $5K
- Small business income: $10K
Total income = $80K
At first glance it appears Tyler is in the $75,213 to $86,354 income range, which should put him in the 32.50% marginal tax bracket according to the tax chart above. But not so fast. Sometimes we need to take a closer look at a situation before we can make an educated assessment.
The more money we make the higher percentage of our incomes should go to the government right? But if that was true, why do some people who earn six-figures have lower tax rates than most middle class people? The answer is because those particular high-income earners are masters at manipulating their tax brackets! #likeaboss
Tyler believes he can use the same tools as the rich and reduce his taxable income in the eyes of the government. Let’s see how he does this.
Bartending $10K: Tyler contributes $10K to his RRSP to buy new investments. Since contributions are deducted from earned income this action essentially nullifies any income tax he owes from bartending 😉
-Rental unit $12K: Tyler’s insurance, mortgage interest, property taxes, and other expenses for the property work out to $12K a year which he can deduct from his rental income and break even. Who knew rental units that are cash flow negative have positive tax benefits? 😉
-Dividends $5K: Since most of Tyler’s dividend income comes from Eligible Dividends, he can claim the federal dividend tax credit. His final tax payable on his dividend income is only a small amount, which is easily neutralized by Tyler’s investment expense tax credit, since he bought some of his stocks on margin.
-Alfalfa business $10K: Tyler was smart enough to run his alfalfa pasture as a small business because businesses pay expenses first, and then pay taxes on any profit left over. After deducting all his expenses, like home office usage, traveling costs, and even interest charges on a business loan, his company will end the year with only a small profit, which will have an insignificant impact when added to his personal income 😉
So by using some clever financial maneuvers 4 out of his 5 income streams are no longer tax liabilities. Tyler is able to effectively lower his $80K of total income to just $43K of taxable income – which is a huge win because only taxable income is used to calculate how much taxes we actually pay, not gross income.
This effectively drops his marginal rate by TWO entire tax brackets from 32.50% to just 22.70%! #winning
So how much savings does a lower tax bracket translate to? Well by using a tax calculator we discover that at $43K of taxable income, Tyler only pays $6,600 in income tax. Which translates into a ridiculously low AVERAGE income tax rate of just 8.25% on the $80,000 gross he makes. Now compare that to Tyler’s boss, a senior manager who works in the same office as Tyler. He also makes $80,000 a year. But since his only income comes from his salary, his taxable income is the entire $80,000 amount, which means his marginal tax bracket STAYS at 32.50% and he has to pay about $17,700 in income tax before RRSP contributions/deductions. Wowzers 😯 #bigdifference!
Both Tyler and his boss are making the exact same upper-middle class income, yet look at the difference between the the 2 green numbers above 😕
Now that’s some SERIOUS tax savings!
Doesn’t seem fair does it 😕 In fact some of you readers may be inclined to accuse Tyler of not paying his fair share of taxes 😡 But unfortunately life isn’t always fair 😐 This is the reality of our tax system. This is how some people can earn over $100K, and still only pay an AVERAGE tax rate of 10% or less.
So we can either adapt to make the tax system work FOR us like Tyler is doing, or we can accept the status quo like Tyler’s boss and complain about how life is unfair, taxes are too high, can’t seem to catch a break, blah blah blah 😛
“Two roads diverged in a wood, and I— I took the one less traveled by, And that has made all the difference.” ~Robert Frost
The good news is we can all be like Tyler and take the less traveled path. Every single one of us has the power to choose how much taxes we pay to some extent 😀 The first step is to understand the difference between taxable income and gross income. The next step is to apply that knowledge.
Using tax deferred vehicles, leveraging to buy real estate, owning investments that pay eligible dividends, using effective tax credits, sheltering viable income generating operations in a small business, and diversifying our income streams in general, are all topics I’ve covered on this blog. These are just some of the many ways we can tip the tax scale in our favor (^_-) #SorryCRA
Random Useless Fact:
Be careful with super glue. If you accidentally get some on your hands you can remove it with acetone (fingernail polish remover.)