Mar 032014
 

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.

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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

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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.

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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!

really_surprised_shock lower income tax bracket

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

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Random Useless Fact:

14-02-supergluemerkel

Be careful with super glue. If you accidentally get some on your hands you can remove it with acetone (fingernail polish remover.)

Mar 242012
 

This is a continuation from the RRSP post earlier this week. There is a legit way to split the income between two people to minimize their overall taxes. It’s called a spousal RRSP and it’s one of the best tax saving strategies available to couples.

How a Spousal RRSP works

In a spousal RRSP one person makes a contribution, but his or her spouse is the owner of the RRSP plan. The maximum amount of spousal RRSP room the couple can make is determined by the contributor’s RRSP room, not the plan’s owner. Below is an example of a hypothetical couple named Hubby (contributor) and Wifey (annuitant), and how a spousal RRSP can help them.

  • Hubby and Wifey are both in the 30% income tax bracket.
  • Hubby contributes $10,000 to Wifey’s spousal RRSP. This money now becomes hers, while he gets the tax credit.
  • Since Hubby puts money into an RRSP, he becomes $3,000 richer from the tax refund. (To get the refund he just files his annual tax return like usual)
  • 2 years later the couple talks about starting a family
  • After another year or so a baby is born

 

 

 

 

 

  • Wifey decides to stay at home to take care of the baby.
  • She does not make any money the following year from her job. But she takes out $10,000 from her spousal RRSP account.
  • Money redeemed from an RRSP is considered income, but in Canada you don’t pay taxes on the first $10,000 you make.
  • So Wifey takes out money from her spousal RRSP tax free.

To summarize, Hubby started with $10,000 of his own after tax income. But by using a spousal RRSP he ended up with $3,000 for himself, and $10,000 for Wifey. Not a bad deal.
And this doesn’t even include any investment income they’ve made over the incubation period from the RRSP contribution to taking the money out again.
Even considering a very conservative 3% annual return, that $10,000 initial RRSP investment would have easily made them an extra $1,000 by the end, all tax free.

Any bank will gladly help people set up a spousal RRSP account. It will be a separate account from someone’s individual RRSP account. The only thing to watch out for is in order for the RRSP withdrawal to be taxed under Wifey’s name, Hubby must not have made any contributions into the spousal RRSP in the current year or the 2 preceding calendar years.
So if Wifey withdraws money any time in 2012, for example, then Hubby must not have made any contributions in the calendar years 2012, 2011, and 2010, because otherwise the withdrawal will be taxed based on Hubby’s income.
There are other small things to keep in mind too. You can find more info on spousal RRSPs in this document, courtesy of Standard Life. I don’t have a family yet, but when I do, I plan to use this strategy.