Now that tax season is behind us, and many of us are enjoying our refunds, we can move on with life and not worry about our taxes for another year. On the other hand, now is a good time to reflect on our taxes and consider how we might improve our tax situation for next year and the years to follow. Before you make any final decisions, you should know the hidden secret of income tax.
How much is my refund?
There is a widespread belief that the objective to filing our tax returns is to maximize our tax refunds. Some taxpayers evaluate the performance of their tax accountant based on the size of the refund they can generate for them. Others who prepare their own returns will test different scenarios to determine which one leads to the biggest refund. This can be an effective strategy as long as one does not arbitrarily break the rules. For example, whether you claim marital status as single or common law is not a choice but a matter of fact.
So what is the secret?
While it makes sense to legally maximize our tax refunds, the secret to income tax is rather to minimize our tax liabilities. One might assume that by maximizing our tax refund we are in fact minimizing our tax liability. This may be true in many cases, but there are subtle differences that should be considered. Maximizing your tax refund is typically a short-term approach that focuses only on the current year. Minimizing your tax liability is more of a long-term plan.
Okay, but what is the difference?
To further illustrate the difference, consider RRSP contributions. The more you contribute (within your contribution limit) in a particular year, the higher your refund will be until you have eliminated your federal tax payable to zero. This would be your approach if your objective was simply to maximize your tax refund. The problem with this approach is that your return on investment from your RRSP contributions (expressed as your marginal rate of tax) diminishes as you pull your net income down into lower tax brackets.
The more effective solution is to contribute enough to your RRSPs to bring your income down into the next lowest tax bracket. This way you enjoy the maximum marginal rate of return from your RRSP contributions for the current year. The unused contribution room is carried forward and you can continue this technique in the years that follow until you run out of room or you hit retirement. This is a fairly simple concept that most taxpayers understand.
What else can I do?
With this example in mind, we can think about other techniques that can be used to minimize our tax liabilities. Having your employer withhold an additional $50 in federal taxes from each pay will certainly increase your refund (or reduce your tax bill) at the end of the year. However, this approach does nothing to reduce your taxes and more importantly it leaves you with less of your own money throughout the year. I call this, a bad idea.
A better alternative is to contribute the same $50 into a tax free savings account each pay period. This technique will keep the money where it belongs. Why give it to CRA before you have to? Didn’t you know CRA does not pay interest on your tax refund? While the money is in your name, it will earn interest for you. And if that money is in a tax free savings account, the interest income is not subject to tax. If you need the money to pay your tax bill at the end of the year you can take it out and pay your taxes when they become due.
There are many other techniques available to most individuals that allow us to defer tax or avoid tax. Taxes can be deferred by pushing income from the current year into future years. Taxes can be avoided by splitting income with a spouse, making charitable donations, or claiming certain other tax credits. Other techniques available to small business owners include incorporating the business, setting up an investment holdings company, and utilizing a family trust.
Where do I start?
The key to any of these techniques is to focus on minimizing our lifetime tax liability rather than on maximizing current year refunds. This is where it pays to work with a tax professional who can help you see the big picture. While you are at it, introduce your tax professional to your investment advisor. This can be a winning combination that helps you maximize your wealth.