Sunday, July 22, 2012

Rule #7 Maximize income in AFTER TAX money.

If, as a big severance package, your company offered you $60000 in any of the following income streams: pension income, capital gains income, employment income, or dividend income, what kind of income would you choose?  Did you think about the taxes?  Most people don't.

I hate paying income taxes. I wont go into it in any detail because it gets political... and I only talk politics if I have a beer in front of me, and I don't right now, so you are spared the rant.  But with that said, we all hate paying taxes, especially on income.  Doesn't it make sense then to try and minimize the amount of tax one pays on your income?  Sure it does. This is called tax avoidance and it is perfectly legal... structuring your income in such a way as to be tax efficient.  I was introduced to this way of thinking about a decade ago when I came across a blog talking about the virtues of dividends... Canadian Corporation Dividends in particular.  There is something called the Canadian Enhanced Dividend Credit, and I won't bore you with details of it, only to say that it results in a lowering of the marginal income tax rate on those dividends.  You can find out more about it here.  

For those who don't know what a dividend is, its a when a company shares a portion of its earnings with shareholders by sending them a cheque... usually quarterly throughout the year.  Those companies have already paid taxes on those earnings, so you don't have to pay as much taxes as you would if it was standard employment income.  Let's have a look at a couple scenarios, where income could be from one of these different streams...  Employment, Capital Gains, RRSP or RRIF withdrawal (remember its taxed when you take it out), Dividends from American Corporations, Dividends from Canadian Corporations (those eligible), and other income.  "Other Income" could come in the form of a pension, rental property, royalties, typical government benefits, some income from REITS, servers tips etcetera.... all of which are taxed at the same rate as employment income.  I don't include business income as I have no experience with owning my own business, nor do I know the intricacies that go with it. 

The two scenarios are $60000 and $100000 in annual income.  The income tax regime is Federal and Ontario, Canada.  The basis of the calculations is from the calculator page where you can run your own scenarios.

So the Total in-pocket amount is the most important column because thats the one that tells you how much you get to keep.  Notice the big difference in taxes from the Investment rows such as Capital Gains and Canadian Dividends (eligible) in comparison to the Employment, RRSP/RIF Withdrawal, and Other Income rows.  Markedly different isn't it. If you made $60000 in Canadian Dividends you would get to keep 97.6% of it, vs the 80% you'd get to keep in employment income.  Note that as an employee you would also be required (don't get me started) to pay CPP and EI premiums which will run you another $3000 a year or so in tax obligations that you wouldn't have to pay if you made your income from dividends or capital gains.  Again with $100000 income, the investment income rows fair substantially better in tax treatment.  When I recognized this a decade ago, I started thinking that there was a type of income that I wanted more of, and other kinds of income that I wanted less of.  It was one of those "Eureka!" moments for me.


Guess what kind of income I prefer. Then guess what I look for when I'm building an investment portfolio.

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