Do you know the tax fundamentals?

admin — Thu, 07 Apr 2011 15:42:46 +0000

Taxes are one of life’s biggest expenses and yet, there is little understanding of the fundamentals. As a Certified Financial Planner, part of my job is to educate my clients on the many different facets of finance. From my experience, tax knowledge is lacking and here I will attempt to educate and spur some interest in taxes. Taking some time to learn the fundamentals can save a significant amount of money over your life time and sets, the ground work for future tax planning.

We must first start with the fundamentals. Calculating your tax owing begins by adding up all of your difference sources of income. These varied sources include employment income, business income, grossed-up dividends, taxable capital gains, and interest income to name a few. Now that we have total income, we can begin to make deductions; this is my favourite part. An example of a common deduction is the amount you contributed to a Registered Retirement Savings Plan (RRSP). A deduction reduces taxable income which means if your income was $34, 000 and you made a $2000 RRSP contribution, your taxable income is now $32, 000. In this scenario based on the marginal tax bracket you are in, the value of this deduction is 20.05% ($401). Now you may ask, ‘what is this marginal tax bracket you refer too?’. Well, in Canada an individual’s tax bracket is a set range of income with a specified percentage of tax payable. To provide an example, the combined 2011 Federal and Provincial tax ranges goes like this:

Up to $37, 774 you will pay 20.05%. The next $3, 770 up to $41, 544 you will pay 24.15%. From $41, 544 to $66, 514 the tax man will charge 31.15%. From here there are a number of additional brackets until an individual reaches an income of $128, 000 at which point any income over this amount is taxed at 46.41%. What you should notice is that not all of your income is taxed at one set percentage; it is taxed in brackets with ever increasing percentage rates to each bracket. The common statement that ‘the government takes half of my money’ is actually incorrect, even though it may feel this way.

Now that we have an understanding of what a marginal tax rate is we can go back to deductions. For people with higher incomes, a deduction is worth more than for someone in a lower tax bracket. Back to the above example, if our RRSP contributor was earning $130, 000 they would save $928.20 on the $2000 they were able to deduct.

Having applied the deductions to total income we have now arrived at taxable income. Do not fret though because we haven’t applied any tax credits yet. Credits are direct reductions in tax owing. A $200 credit is worth exactly $200 to you, regardless of what tax bracket you are in. There are two basic types of credits though, refundable tax credits and non-refundable tax credits. Refundable tax credits are treated as having been paid to you, even if you owe no tax. A non-refundable tax credit is worthless if you owe no tax. The bottom line after this process is the balance owing or, hopefully, a refund owing to you.

If you have investments in a Non-registered investment account you will have to understand the different taxation on Interest, Dividends and Capital Gains. Interest income is treated the same as employment or business income. Everyone is familiar with interest income as common investment vehicles such as Guaranteed Investment Certificates (GICs), savings accounts and bonds pay interest. Simply, the higher your income level the more tax you will pay on this income. If you have a spouse in a lower tax bracket consider having any interest bearing investments in their name. Dividends are distributions of after tax profits to shareholders of a corporation. A dividend has preferential tax treatment compared to interest income, but is more complicated to calculate. Since a dividend is after tax profit paid from a corporation, to avoid double taxation a dividend is grossed up by 41%. So, a $100 dividend is grossed up to $141 and is included as total income. Tax is calculated on the grossed up amount, but then a Federal 16.44% and 6.4% Provincial dividend tax credit is applied later to reduce the total tax payable. These credits are based on the grossed up dividend amount. Dividend income is more tax efficient than interest income, but if you are in receipt of Old Age Security (OAS) the government will begin to ‘claw back’ your OAS benefit if income is over $67, 668. Caution must be taken because the dividend gross-up will increase total income which is then used to calculate if there will be any OAS claw back.

Finally we have Capital gains and losses. A capital gain is when the purchase price is lower than the sale price of the asset or investment such as a stock, bond or mutual fund. If you made money, a capital gain, you must include 50% of the gain on your tax return in the year the profit is made. In the unfortunate event there is a loss you will be able to offset any capital gains for that year or in any of the previous three years. Alternatively, you can carry forward the capital loss indefinitely. This is where tax knowledge comes into play. For instance, if in 2009 you were in a higher tax bracket and had capital gains in that year it would be advantageous to use your current capital losses and carry them back to 2009 to use against the gains. The reason you would do this is that there will be a larger tax savings when you are in a higher tax bracket. Many people transfer shares in-kind to their RRSPs or TFSA, but are not aware of the tax consequences. Say for instance you own XYZ shares and decide you don’t want to sell them, but would like to transfer or contribute them to the above two accounts. If you proceed, as far as CRA is concerned, this is a deemed disposition for tax purposes. Essentially CRA is treating the transfer as if you had actually sold them. If there is a capital gain on XYZ shares then you must record this on your tax return for that year even if you didn’t actually sell the shares. Something even more important, if there is a capital loss on the shares and they are transferred in-kind to an RRSP or TFSA this loss will not create a usable capital loss. In this situation, give consideration to selling the shares prior to transferring the funds into an RRSP or TFSA. This strategy will allow you to capture the capital loss. To this point, CRA has a rule called the superficial loss rule. If you sell property (ie. Shares) to trigger a capital loss and either you, your spouse or a corporation controlled by either of you acquires the same property 30 days before or after the sale then the sale is considered a superficial loss and will not create a usable capital loss. If this does occur, then the unusable capital loss will be added to the newly acquired properties adjusted cost base. In effect, you will be able to use the loss, but not at your desired time. A common strategy come year end is to sell off shares that have a capital loss, often called loss selling. The benefit of this is that you will be able to utilize these capitals losses on your tax return and won’t have to wait an entire year to take advantage of this. Having said this, if you sell shares with a gain at the beginning of the year you are effectively able to defer tax on the capital gain until you have to file your taxes the following year. This is money you would otherwise have to pay to CRA and have in your possession to do something productive with.

Now you may ask which of interest, dividends or capital gains is the most tax efficient. Well, it depends on what your income level is. Interest is obviously the last type of investment income you would want as it is fully taxable, but it is normally generated by lower risk investments which are appropriate for many people. The real question is which are better, capital gains or dividends. The inflection point is roughly when your income is $80, 000. If you are above this amount then capital gains are the most tax efficient, but if you are below this then dividends are the most tax efficient. There is an inherent issue with capital gains; you need to actually make a profit which, as many of you know, is easier said than done.

Understanding the fundamentals is vital and will be a great asset when planning your financial affairs. In my next article I will discuss various tax planning strategies, deductions and credits. In the mean time, happy filing!

Normaxx Financial Group Ltd.

Do you know the tax fundamentals?