Oh dear, it’s that time of year again…tax season is upon us, and as our various tax related slips keep coming in the mail I’m getting ready to plug everything into some software and find out what we owe (hopefully) otherwise I just gave the government a interest free loan for the last year.
Yet during the last week I’ve had numerous tax related questions asked of me at work. I’m not an expert by any stretch of the imagination, but I have developed a few rough rules to help people keep things straight in their head.
- Marginal Tax Rate Isn’t Average – People in Canada often like to complain about their marginal tax rate, or how much tax they pay on your last dollar of income. Yet they can often confuse that with their average tax rate, which is the amount you pay overall on your income in percentage terms. So people like to whine they pay a 39% tax on their income, when in fact the average might be closer to 20%.
- Not all Income is Taxed the Same – Keep in mind the basic classes of income when you do things. Interest income or profit from an unincorporated business is considered other income and gets taxed at your marginal tax rate (ie: the highest rate for you). Meanwhile capital gains which you earn when you sell a stock in a taxable account for a profit is taxed at only half your marginal rate (like a permanent 50% off sale and keep in mind you only get taxed at profit part, your original investment is tax free). Then finally you have dividend income which you get a big fat tax credit on, so even at higher incomes you often are taxed even lower than capital gains and for those at incomes less than $40,000 it can be close to tax free (at least from Canadian companies, US will be a be higher).
- Know Your Tax Shelters – RRSP are not an investment, they are a vessel for your investments that let’s it grow tax free. So when you put money in your tax a refund of the taxes you paid on that income. Yet you have to pay tax when you pull the money out, so your delaying the tax, not entirely avoiding it. A TFSA is again a vessel, not a savings account. Here you get no tax refund, but the growth again isn’t taxed, but the real bonus of this one is when you take money out you don’t pay a dime in tax. Here you are avoiding tax. So if you don’t know which to use, default to the TFSA first and for the love of god don’t just use it as a savings account for your next vacation, it’s a waste of a good tax shelter which could give you a tax free stream of income in retirement.
- Don’t Let Tax Savings Rule Your Investments – Obviously consider tax implications when investing, but a bigger issue is often the fees from your investments. You pay fees every year on mutual funds, but if the money in in an RRSP you only pay the tax once when you take it out. So a 1% difference in fees for 30 years are a bigger issue than which tax bracket you are in. If the only reason you are going to buy an investment is tax reasons, it is usually a bad idea.
- Ask for Help – If you don’t know, go find some help. I personally like the website TaxTips.ca as it is packed with useful information and I’ve yet to come across an error on the site.
So what tax questions do you hear about from others? Any other common misunderstandings you hear about?