Saving and investing is easily the most popular topic in personal finance, especially investing. There are literally thousands of opinions and strategies out there regarding investing, and it’s no doubt important to be able to sift through it all and understand it in order to make the correct allocation decisions for your portfolio. But what most people forget is that the key to building wealth is saving, not investing.
The best piece of advice regarding saving? Spend less than you earn.
How important is saving? I couldn’t possibly overstate its importance, especially in today’s day and age. There’s not much more to say about it. You need to save. Well, you might ask, isn’t it a bit early to start thinking about retirement? While I do think it’s never too early to think about retirement, plenty of financial advisors would agree with you. Regardless, what I would recommend is that you have to have a plan and set some goals, even if they may be meagre. The worst way to approach your financial wealth situation is just earn income and spend it, in a kind of aimless way. So many couples have done that for the first 15-20 years of their marriage, only to wake up in their mid-40’s and find out that their dream retirement lifestyle may not be attainable. You need to have some sort of plan and set goals around that plan.
So you’re ready to set some goals, eh? But where do you start? You first have to understand your current financial situation in its entirety. How can you make a decision about your financial future if you don’t know what’s presently happening? First of all, you must know the extent of your assets. How much money do you have in the bank? What’s the total amount of assets you own? Next, what’s the total amount of liabilities that you have? As well, for each liability, what interest rate are you paying on that debt?
Assuming you know your current monthly income, how are you spending that income? In order to save, you need to know your current expenditures. I have attached an excel file which breaks down an average family’s expenses and provides a really simple way of tracking your own expenditures.
https://docs.google.com/fileview?id=0B7Pb2iJ73yaOMzcwZmEwYTgtNTBhNy00MjA5LThmMjEtNzgzNzNhYWIzNDA3&hl=en
(Press "Download" on upper left corner)
Note that the numbers I chose on the file are completely random (based on a $50,000/year income); you can fill in your own. Let me break it down for you:
Line 5 – enter your total monthly income.
Lines 8-14 – these are your fixed expenses that generally stay the same each month. Notice that I have a ‘savings’ account for line 14 – I’ll talk about this later.
All lines after that are your variable expenses that change on a monthly basis. You can write a quick description of what the expense is (as I have) and then the expense amount.
You can add in as many lines as you like (my chart has more than 50 lines – Microsoft Excel gives you 32,000 lines, so you should be ok), or subtract them if needed. As well, certain expenses are paid once a year but can be spread out for the whole year. For example, a synagogue membership or insurance payment is often made once a year. However you can divide the total payment by 12 and enter it as a monthly fixed expense (otherwise known as accrual accounting).
Line 3 automatically subtracts the sum of all your expenses from your monthly income to get your final balance for the month. You can update this excel file once a month. Assuming that you mostly pay everything with a debit and/or credit card, you can simply log onto your account online, see your expense, and copy them over one by one. If you spend a lot of cash, it may be tougher to keep this file, but try your best. Spending 10 minutes a month updating this excel file will keep you in touch with the money you are spending.
A word for the wise: Don’t be too specific about your expenses. For example, if you recently spent $100 at Metro, don’t break it down by the margarine, breads, etc. This will drive your spouse insane. A general number is good enough. Just put $100 down and write “metro” next to it.
I honestly think that the exercises shown above are the most important steps to building a stable financial situation for your future. All the other stuff concerning investments, mortgages, RRSP’s, etc. are important, but if you aren’t keeping track of your financial situation at least a few times a year, then those investments won’t get you anywhere. These exercises also give you the tools needed to begin saving. Even if you don’t have a grand financial goal, or have yet to determine an appropriate monthly savings amount, at least just start with a really meagre goal – perhaps $100/month. Put that amount in as an expense – the best way to save is to take it off the top, rather than waiting for your ending balance to determine your monthly savings (line 14 on the excel chart!). Any positive amount left on your monthly balance can be an added bonus to your savings, or you can use that as a treat – maybe go out to a nice restaurant, or save that for a vacation.
The obvious question that I haven’t addressed is: How much do you actually have to save on a monthly or annual basis? You ask that question to any financial advisor in the world, and they’ll look right back at you and ask, “What are you saving for?” In other words, what are your lifestyle goals, both in the short-term and long-term?
Your answer can include buying a house, sending my children to private school, taking an annual vacation to Europe, buying all my clothes at Holt Renfrew, etc. Your lifestyle goals will determine your savings needs.
Most young couples are probably worried about: How much money do I need to buy a starter home? I will deal with this question in the future. The important thing is that you understand what it takes to begin creating a savings plan. Even if you are unsure of anything in particular, as I said before, at least just make a small savings goal (of $100/month are whatever you’re capable of) and keep track of your monthly expenses. These simple acts will go a long way to improving your financial situation both in the present and for the future.
Next week I’ll discuss portfolio allocation.
Sunday, March 21, 2010
Thursday, March 11, 2010
An Introduction to Tax Planning and Strategising
In the last post, I explained to you how the tax system works and how to actually file a tax return. Now I am going to delve a bit into how to save as much money as possible from the dreaded taxman. Firstly, I want to explain 3 concepts:
1) Understand the objective here: Keep as much money away from the government as possible and in your own pocket! Believe me, the government is pretty serious about taking money from you and they won’t go easy in any sense of the word, so why should you? Make sure you utilize all the deductions and credits possible to your best advantage. I know that sounds elementary, but as I mentioned in the last post, people seem to shy away from tax strategising. They’ll go to the supermarket and make sure to save $0.50 on a loaf of bread, but to fill out 4 pages of forms to save $750 on their taxes is for some reason out of their realm.
2) Secondly – Don’t be intimidated by the CRA! What do I mean? Well, the CRA is just a government organization that enforces the Income Tax Act. They have no say on their own. If there is a disagreement between the filer and the CRA, it’s all processed and arbitrated by a third party, the court system, who has no prejudices either way.
How to apply this concept? Well, there are some deductions/credits on your form that you may be unsure about regarding whether you qualify for it or not. Either ask an accountant, or just put it in! The worst that can happen is that the CRA will not accept it, and give you the option of going to a court to fight over it. It may be a crime to provide fraudulent numbers, or to not file a return at all, but interpreting the Income Tax Act in a different way (than the CRA) is perfectly legit! A court will decide for you; or, once the CRA calls you out on it, just let it be and pay the extra tax. (Obviously, you have to be reasonable about this, and it is a crime to make up numbers!)
You know – I have a lot of friends who like to tell me stories about traffic tickets they incurred and how they went to court and fought it and won. I find it incredulous that you have no problem openly disagreeing with and taking to court a 6”4, 220 pound police officer, with a gun and plenty of other weapons on his belt, but that nerdy, 140 pound CRA auditor – that’s the guy you’re scared of?
3) My 3rd point regards accountants. Are they worth it? The easy answer is, it depends. The first rule of thumb is that the more complicated your return, the more the worth of an accountant. If you are filing a T2 (corporate return), then it is almost guaranteed that an accountant is worth your while. Not only will he save you many hours of work, but he can identify numerous deductions and save you a lot of money, which is the objective here. Truth is, I would advise hiring an accountant in most circumstances (even for T1’s), but with one caveat:
Accountants are NOT paid by how much money they save you on your tax return. Personal accounting is for the most part a volume service. Accountants try to pump out as many returns as possible in the fastest times possible. In other words, there are no incentives for them to spend extra time with you to go over every deduction that you may have expensed in the previous year and see if it applies to you. That’s why I believe that even if you use an accountant, you should be aware and keep up to date with how the tax system works and all the credits and deductions possible, so that you can refer them to your accountant.
Finally, it is pretty imperative to understand what your accountant is doing. I’m not saying all accountants are crooks, but in case you didn’t know – you are just as responsible for the information put on a tax return by your accountant as had you filed it yourself.
There are numerous tax strategies and tips that can benefit you; only a proper accountant can really recognize and apply them all (and a good one, for that matter). As well, almost every other decision in personal finance needs to have tax planning incorporated into it (especially investments!), so when I get to those topics, I will explain the relevant tax strategies related to them. For the actual annual tax return, my best advice is just to go through the deduction and credit lines one by one, and read the guidebook. However, I will go through a couple of tips here, and feel free to ask me any other questions regarding taxes.
Let’s examine some of the deductions and credits that you may have not realized you can deduct:
Line 368 on the tax return outlines the Home Renovations Credit. Do you have any idea how many things you can deduct here? See http://www.cra-arc.gc.ca/E/pub/tg/5000-g/5000-g-04-09e.html#Ex_eligible . Basically, if you own a property, there’s no reason in the world why you shouldn’t try maxing this credit out. Just make sure that you don’t lose the receipts for whatever services or items you purchased throughout the year.
Line 349 is for charitable donations. Did you know that you can claim charitable donations from 5 years ago? There is an important point here: If you earn a relatively small income now, and your current marginal tax rate is low, but you expect it to increase in the next few years, it might be worth it to wait to claim the donation later. For example, if you’re currently in school, but expect to graduate and start working in the next tax year, you’re probably earning very little money right now. Why not wait a few years until your tax rate wait is much higher and you’re earning a larger income? Just make sure that you don’t lose the tax receipt! (Keep it in that binder I told you about).
Line 319 – This line is for interest paid on your student loans. First of all, it has the same applications as does charitable donations (5 years to claim). Secondly, if you’re still in school, why not apply for a student loan, even if you may have the cash to pay the university? The cash can be put away and if done properly, can earn more interest than the rate being paid on the loan, and also, you get the interest credit back from the government!
Line 330 – This line is for medical expenses. Read through the guidebook or online guide (http://www.cra-arc.gc.ca/E/pub/tg/5000-g/5000-g-04-09e.html#P1310_177996) about this subject! Do you know you can deduct your contact lens purchases throughout the taxable year? Or prescription drugs, eyeglasses, private health insurance premiums, and even the travel costs to get the medical treatments if it is more than 40KM away from your home?
As well, do you know that either you or your spouse can claim these medical amounts? If your spouse is in a higher tax bracket, why not have him/her claim it so you collectively save more on your taxes? Furthermore, there are many credits that either spouse can claim – think about who should claim it, it could save you hundreds of dollars.
Compensation Plans – This doesn’t usually apply to younger workers, but it’s still important to know. Different types of income are taxed at different rates. For example, capital gains are taxed at 50%, meaning that if you made $100 in capital gains, you only pay taxes on the first $50. Dividends are also taxed less. Therefore, if your boss wants to give you a $5,000 bonus for good work – why not ask him to give it to you in a separate form instead of cash? Ask for the bonus in dividends, stock options, ownership interest, chocolate milk – anything but cash! As well, when initially applying for a job, recognize the extra value of employee benefits. Let’s say your employer offers you $5000 in income, or free health insurance. Remember that the health insurance is untaxed, so whatever monetary value it represents is the actual amount its worth. However, the $5000 in cash might only be worth $2500 by the time the government is through with you.
I could go on for 50 pages with these types of tips. But I’ll probably go crazy. However, if it’s one thing you’ve learned here, I hope it’s the fact that deductions are almost endless, and it is really worth your while to go over all the possible deductions and read the guidebook carefully. You can save a ton of money by just filling out forms and saving receipts. One of my professors in Schulich used to say that if you’re paying any taxes on your first $20,000 of income, then you’re doing something wrong.
Conclusion about Income Taxes: The most important concept in personal finance is the saving and accumulation of wealth. Cutting down on certain expenses, such as clothing and entertainment, may be a requirement for your financial health. But before you start cutting on these enjoyable activities in order to save money, why not save money in all other ways first? Whereas cutting leisure expenses should be the last resort on your list, maxing out tax savings should be one of the first.
Next week I’m going to talk about another tax-related topic: registered savings plans.
1) Understand the objective here: Keep as much money away from the government as possible and in your own pocket! Believe me, the government is pretty serious about taking money from you and they won’t go easy in any sense of the word, so why should you? Make sure you utilize all the deductions and credits possible to your best advantage. I know that sounds elementary, but as I mentioned in the last post, people seem to shy away from tax strategising. They’ll go to the supermarket and make sure to save $0.50 on a loaf of bread, but to fill out 4 pages of forms to save $750 on their taxes is for some reason out of their realm.
2) Secondly – Don’t be intimidated by the CRA! What do I mean? Well, the CRA is just a government organization that enforces the Income Tax Act. They have no say on their own. If there is a disagreement between the filer and the CRA, it’s all processed and arbitrated by a third party, the court system, who has no prejudices either way.
How to apply this concept? Well, there are some deductions/credits on your form that you may be unsure about regarding whether you qualify for it or not. Either ask an accountant, or just put it in! The worst that can happen is that the CRA will not accept it, and give you the option of going to a court to fight over it. It may be a crime to provide fraudulent numbers, or to not file a return at all, but interpreting the Income Tax Act in a different way (than the CRA) is perfectly legit! A court will decide for you; or, once the CRA calls you out on it, just let it be and pay the extra tax. (Obviously, you have to be reasonable about this, and it is a crime to make up numbers!)
You know – I have a lot of friends who like to tell me stories about traffic tickets they incurred and how they went to court and fought it and won. I find it incredulous that you have no problem openly disagreeing with and taking to court a 6”4, 220 pound police officer, with a gun and plenty of other weapons on his belt, but that nerdy, 140 pound CRA auditor – that’s the guy you’re scared of?
3) My 3rd point regards accountants. Are they worth it? The easy answer is, it depends. The first rule of thumb is that the more complicated your return, the more the worth of an accountant. If you are filing a T2 (corporate return), then it is almost guaranteed that an accountant is worth your while. Not only will he save you many hours of work, but he can identify numerous deductions and save you a lot of money, which is the objective here. Truth is, I would advise hiring an accountant in most circumstances (even for T1’s), but with one caveat:
Accountants are NOT paid by how much money they save you on your tax return. Personal accounting is for the most part a volume service. Accountants try to pump out as many returns as possible in the fastest times possible. In other words, there are no incentives for them to spend extra time with you to go over every deduction that you may have expensed in the previous year and see if it applies to you. That’s why I believe that even if you use an accountant, you should be aware and keep up to date with how the tax system works and all the credits and deductions possible, so that you can refer them to your accountant.
Finally, it is pretty imperative to understand what your accountant is doing. I’m not saying all accountants are crooks, but in case you didn’t know – you are just as responsible for the information put on a tax return by your accountant as had you filed it yourself.
There are numerous tax strategies and tips that can benefit you; only a proper accountant can really recognize and apply them all (and a good one, for that matter). As well, almost every other decision in personal finance needs to have tax planning incorporated into it (especially investments!), so when I get to those topics, I will explain the relevant tax strategies related to them. For the actual annual tax return, my best advice is just to go through the deduction and credit lines one by one, and read the guidebook. However, I will go through a couple of tips here, and feel free to ask me any other questions regarding taxes.
Let’s examine some of the deductions and credits that you may have not realized you can deduct:
Line 368 on the tax return outlines the Home Renovations Credit. Do you have any idea how many things you can deduct here? See http://www.cra-arc.gc.ca/E/pub/tg/5000-g/5000-g-04-09e.html#Ex_eligible . Basically, if you own a property, there’s no reason in the world why you shouldn’t try maxing this credit out. Just make sure that you don’t lose the receipts for whatever services or items you purchased throughout the year.
Line 349 is for charitable donations. Did you know that you can claim charitable donations from 5 years ago? There is an important point here: If you earn a relatively small income now, and your current marginal tax rate is low, but you expect it to increase in the next few years, it might be worth it to wait to claim the donation later. For example, if you’re currently in school, but expect to graduate and start working in the next tax year, you’re probably earning very little money right now. Why not wait a few years until your tax rate wait is much higher and you’re earning a larger income? Just make sure that you don’t lose the tax receipt! (Keep it in that binder I told you about).
Line 319 – This line is for interest paid on your student loans. First of all, it has the same applications as does charitable donations (5 years to claim). Secondly, if you’re still in school, why not apply for a student loan, even if you may have the cash to pay the university? The cash can be put away and if done properly, can earn more interest than the rate being paid on the loan, and also, you get the interest credit back from the government!
Line 330 – This line is for medical expenses. Read through the guidebook or online guide (http://www.cra-arc.gc.ca/E/pub/tg/5000-g/5000-g-04-09e.html#P1310_177996) about this subject! Do you know you can deduct your contact lens purchases throughout the taxable year? Or prescription drugs, eyeglasses, private health insurance premiums, and even the travel costs to get the medical treatments if it is more than 40KM away from your home?
As well, do you know that either you or your spouse can claim these medical amounts? If your spouse is in a higher tax bracket, why not have him/her claim it so you collectively save more on your taxes? Furthermore, there are many credits that either spouse can claim – think about who should claim it, it could save you hundreds of dollars.
Compensation Plans – This doesn’t usually apply to younger workers, but it’s still important to know. Different types of income are taxed at different rates. For example, capital gains are taxed at 50%, meaning that if you made $100 in capital gains, you only pay taxes on the first $50. Dividends are also taxed less. Therefore, if your boss wants to give you a $5,000 bonus for good work – why not ask him to give it to you in a separate form instead of cash? Ask for the bonus in dividends, stock options, ownership interest, chocolate milk – anything but cash! As well, when initially applying for a job, recognize the extra value of employee benefits. Let’s say your employer offers you $5000 in income, or free health insurance. Remember that the health insurance is untaxed, so whatever monetary value it represents is the actual amount its worth. However, the $5000 in cash might only be worth $2500 by the time the government is through with you.
I could go on for 50 pages with these types of tips. But I’ll probably go crazy. However, if it’s one thing you’ve learned here, I hope it’s the fact that deductions are almost endless, and it is really worth your while to go over all the possible deductions and read the guidebook carefully. You can save a ton of money by just filling out forms and saving receipts. One of my professors in Schulich used to say that if you’re paying any taxes on your first $20,000 of income, then you’re doing something wrong.
Conclusion about Income Taxes: The most important concept in personal finance is the saving and accumulation of wealth. Cutting down on certain expenses, such as clothing and entertainment, may be a requirement for your financial health. But before you start cutting on these enjoyable activities in order to save money, why not save money in all other ways first? Whereas cutting leisure expenses should be the last resort on your list, maxing out tax savings should be one of the first.
Next week I’m going to talk about another tax-related topic: registered savings plans.
Thursday, March 4, 2010
Income Taxes! An Introduction
Taxes may be the most boring subject in the world, but its importance is very undervalued. Critically undervalued, for that matter. I have many friends who get all excited when telling me about a certain mutual fund or stock pick that gives 2% higher returns than expected – do you know how much the government takes from you? For many people, it’s almost 50% of your next dollar earned! Even one extra tax credit can equal to huge savings, yet people completely forget about tax planning and strategising, in order to focus on investment returns. In all of personal finance, I would say that tax planning is the most critical issue of all and ultimately has the biggest impact on your financial well-being.
In this post, I’m going to talk about the basics of income taxes – tax structure, how to fill out tax forms, etc. For many of you, this knowledge is basic and redundant; next week I will start talking about tax strategising and planning so that you can learn how to keep the most money away from the dreaded taxman, and also the impact and value of hiring a tax accountant.
First of all – who needs to file? Well, anybody who makes any kind of income. (That’s the legal answer). A lot of students who don’t earn much money don’t start filing until they enter the workplace. My advice is to start filing as early as possible. There are certain benefits to filing early even when your income is relatively small (the biggest being building RRSP contribution room for the future), which will be described later. It is extremely simple to file a return with no income.
How and where do I file? Well, there are various ways you can file – online, through a software program, or actually getting the forms and filling them out, the way our ancestors did it. Personally, I file the ancient way just because it’s the cheapest. You can pick up the forms at any Canada Post Office at this time of year. There are 2 booklets – the actual forms booklet, and the guide booklet. Make sure you pick up both for each tax filer.
These booklets contain what’s called a T1 – or personal income tax form. If you are self-employed, you need to file additional forms, including the T2125, and if you own any type of corporation, things get even trickier, and you need to file a T2, or corporate tax return. For simplicity’s sake, I will only be discussing T1’s – the return filed for the personal income you earned.
What do I need to file? Taxes involve a lot of various forms and papers. For starters – you need all of your T4 and T5 statements. These papers list the income earned by each T4/5 provider. Your employer(s), bank, investment firm – all of these institutions should have mailed you T4/5’s by the end of February. If you haven’t received them by March or you lost them, be sure to call the institution and have them print you extra copies. Hopefully now you know that the next time the bank sends you that small, double-copied paper, you won’t throw it out. As well, you need any other paper that’s used for tax credits – charitable donation receipts, insurance receipts, etc.
Here’s a great tip. At the beginning of each year, buy a binder and stick every single paper (related to tax returns) that you receive throughout the year in it, including employment papers, receipts, etc. That way, at the end of the year, you won’t go searching everywhere for those papers, because I’m not kidding – you really do need them.
Next, we will talk about the structure of the Canadian tax system. When we talk about income taxes, there are actually two entities taxing us – the federal government, and the provincial government. You actually have to fill out 2 forms, one for each government (don’t worry, it’s all included in that booklet you picked up from the Post office). First I’ll explain the federal system:
Federal Tax Brackets (Canada)
These are the 2009 federal tax rates on your income. Notice the structure here – it’s a ‘progressive’ structure. In other words, you pay $0 of taxes on your first $10,320 of income, 15% on the next $30,406 of income, and so on. If I’m earning $126,265 which is $1 above the last tax bracket threshold, my tax rate isn’t 29% - I only pay 29% on the one dollar earned above $126,264.
This should dispel a common myth about taxes. A lot of people have this idea that it’s bad to accept extra dollars of income if it pushes you over one of the tax brackets and into the next bracket. For example, if I currently earn $80,000 of income, and my marginal tax rate is 22%, and then my boss offers me a $5,000 raise (which would put me in the 26% bracket on my marginal dollar) – I might get smart and say “nice try boss! I’d rather stay in the lower tax bracket.” That reasoning is completely flawed – you only pay the higher tax rate on the extra dollars earned above the last bracket! So you should always accept more income! (I never thought I’d have to say that to someone....)
As you can see, the Ontario system works similarly but with different numbers.
So that’s it, right? Nope! Ontario charges you even more taxes, called surtaxes. This is calculated by finding your tax amount and then multiplying it by a number, depending on the tax size. That’s why there’s no set tax rate. Every person pays a different amount of tax, depending on their income and deductions. To give you an example, a typical person earning $200,000+ will be paying about 48% of taxes on their next dollar earned.
T1 – Personal Tax Form
The first page of the T1 General Form (“Income Tax and Benefit Return”) asks you for some identification. The second page asks for your income. You have to input the correct numbers on their corresponding line. To figure out what goes where, you need to use the Guide booklet. It will tell you which numbers on your T4’s goes on which line on the T1. Some of the lines (like line 121) ask you to fill out a schedule if you have that type of income. Those schedules are all included in the booklet somewhere – you just have to find it. Also, don’t get confused by the double pages – it’s just a second copy of the same document.
Line 150 is your total income. The third page allows you to deduct from your income (that’s a good thing!). Go through the lines and see if any apply to you. It is definitely worth your while to do this part carefully – adding in a number to one of those lines could mean hundreds and even thousands of dollars of tax savings.
Finally, line 260 is your taxable income. At this point, you have to fill out Schedule 1 to find the taxes payable on your taxable income. Again, go through lines 300 – 350 slowly. You want to maximise your tax credits. It can get incredibly annoying, because many lines require even more worksheets. But I cannot stress enough the savings possible – you can literally save hundreds of dollars per worksheet you fill out. If that isn’t worth your time, I don’t know what is.
Finally, at the end of Schedule 1, you come to line 420, which is your taxes payable. This number is put back on line 420 on page 4 of the T1. After that, you deduct income taxes already paid, including CPP and EI payments. How do you know if you paid taxes already? Look at your T4’s – the employer often takes off income tax for you, and CPP and EI, as required by law. Finally, you come to line 482, which is your final tax bill.
Line 482 may be negative, which means the government will mail you a refund. People get really excited by refunds, and often strive to receive a tax refund. That’s not a good thing – the only reason why you’d have a refund is because you paid too much taxes throughout the year. As such, the government got a 1 ½ year loan on your money for free. If you consistently have large refunds, ask your employer to take taxes off your regular paychecks at a lower rate. Owing taxes at the end of the year is a good thing – it means you’ve held off as long as possible to pay your taxes.
Last point – what I said before about refunds being a bad thing is only applicable if you’re a disciplined saver. If you are the kind of person that always spends money as you receive it, it may be better to continue having your employer deduct taxes for you. That way, you won’t end up at the end of the year with a big tax bill, and then wondering where all that money went.
This is the structure of income taxes. It’s a long, boring process, but it’s the most monetarily worthwhile thing to spend your time on. Next week I will delve deeper into the different deductions and credits on the T1, and show how you can manipulate those deductions and credits as much as possible.
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