Personal Finance Chapter 3

Chapter 3 – Planning Your Tax Strategy    Taxes and Financial Planning About one-third of each dollar you earn goes to pay taxes. An effective tax strategy is vital for successful financial planning. Understanding tax rules and regulations can help you maximize after-tax cash flows and net worth.            Four Types of Taxes Taxes on purchases. Sales tax & excise tax. Taxes on property. Real estate tax. Personal property tax. Taxes on wealth. Estate taxes. Capital gains (losses). Dividends. Taxes on ordinary income/interest Income tax.    Progressive Tax System Federal and most provincial taxes are based on a progressive tax system The premise is ‘that the more you make the more you pay’ Under a flat tax system, everyone pays the same rate of tax regardless of one’s income level       Step 1: Determining Total Income Total Income consists of five main components Employment income (remuneration for personal effort) Net business income Investment income Taxable capital gains Other income – retirement income, Old Age Security, child support payments, education-related payments TYPES OF INCOME         Step 2: Calculating Net Income Deductions Allowable deductions are deducted from Total Income to determine taxable income. Examples include: Contributions to RRSP & RRP Union and professional dues Child care expenses Moving expenses Taxable Income is the net amount of income after allowable deductions on which income tax is computed. Step 3: Calculating Taxable Income • Once net income has been determined, additional deductions and losses carried forward from previous years are permitted in determining taxable income      Step 4: Calculating Federal taxes owing Taxable income is basis for computing amount of your income tax owing Marginal Tax Rate (MTR) Is rate of tax paid on the next dollar of taxable income Average Tax Rate (ATR) Total tax due divided by total income  Marginal Tax Rate An Alberta resident with an annual income of $60,000 has a marginal tax rate of what amount?    Formulas: Average Income Tax Rate (ATR)= Total Income Tax Payable Total Income Marginal Tax Rate (MTR) = Highest federal tax rate + highest provincial tax rate Or the tax rate a tax payer would pay on his/her next dollar of taxable income What is the value of a deduction? • The value of a deduction is: • MTR x $value of deduction = Income tax saved • Therefore, the higher your MTR, the higher the value of the tax deduction • If Mike’s MTR is 39% and Mary’s MTR is 32%, what is the immediate tax saving (value) of a $1000 RRSP contribution?     Step 5: Calculating Net Federal Tax Tax Credit An amount subtracted directly from the amount of taxes owing Non-refundable tax credits are subtracted from the amount of taxes owed but can never reduce federal tax below zero Refundable tax credits are refunded to individuals if they qualify even if their tax liability is zero           Examples of tax credits include; Basic personal amount Age Amount (65 or older) Infirm Dependant (over 18 years old) Spousal (equivalent-to spouse) amount Contributions to CPP / EI Caregiver Amounts Disability amount Tuition and education expenses / interest on student loans Medical expenses Charitable donations  Making Tax Payments Source Withholding        Employees withhold from source to pay income tax, CPP and Employment Insurance contributions Reported to you on your T4 Can reduce source withholding Installment Payments Deadlines & Penalties Must file by April 30 of each year Automatic 5% penalty on balance owing if late   Record Keeping Requirements Keep your tax records for 6 years Keep all official receipts as well as bank records and cancelled cheques    Tax-Planning Strategies Tax planning is the use of legitimate methods to reduce one’s taxes Tax Evasion is the use of illegal actions to reduce one’s taxes To maximize after tax cash flow some strategies should be considered Taxes on Wealth Registered Retirement Savings Plans • An investment vehicle that allows you to shelter your savings from income taxes. • You can hold a variety of investments within an RRSP • Two Types • Basic • Self Directed • Contribution Limits • 18% of earned income less contributions to pension plans • Unused contributions can be carried forward to subsequent years • The RRSP contribution is a tax deduction and therefore results in an immediate tax saving Tax Free Savings Accounts (TFSA) • All Canadian residents, aged 18 or older, can contribute to a TFSA. • Investment income earned in a TFSA is tax-free. • Withdrawals from a TFSA are tax-free. • Unused TFSA contribution room can be carried forward. • Full amount of withdrawals can be put back into the TFSA in future years. Recontributing in the same year may result in an over-contribution amount, which would be subject to a penalty tax. • Contribution limits: • 2009, 2010, 2011, 2012: $5000 per year • 2013, 2014: $5500 per year • 2015: $10,000 per year      Tax-Planning Strategies Tax issue important to students Learn how to report income from scholarships, bursaries, fellowships, grants and RESPs Get common deductions such as moving expenses, child care expenses and interest paid on student loans Non-refundable tax credits such as tuition and education amounts Other tax credits such as GST/HST credit and Canada Child Tax Benefit