Taxation "Arbitrage", Also Known As Free Money

StockMonkeys.com

It's tax season and decisions regarding whether or not to contribute to RRSPs is upon us, assuming no automatic contribution vehicle is in place. What to do!?

In a previous post, I suggested that taxation levels should cause us to assess the value of every incremental dollar of earned income to ensure it makes sense to continue to exchange time and effort for money, given the diminishing returns.

That being said, if the answer is "yes" it does make sense to earn the extra income, then sheltering at least a portion of this additional income makes sense. Once your incremental earned income is beyond the level you expect to earn during retirement, putting the difference into a tax-deferred account such as RRSPs and Spousal RRSPs offers significant upside. The higher your tax bracket, the closer you get to a 2 for 1 special: at the 46%* level , each RRSP dollar is worth nearly 2 net dollars, which is the interest free loan to save money you will ever get! 

When you withdraw these dollars at a lower level of taxation in the future, you not only benefit from the growth in a tax-deferred account, but you also benefit from the lower level of tax you have to pay compared to what you would have paid when you first invested the funds:

• $10K taxed at 46% nets $5,400 after tax now
• $10K taxed at 46% put in RRSP nets $10K before tax** now & available for investment
• $10K taxed at 35% upon withdrawal*** nets $6,500 as retirement income

Difference = $6,500 - $5,400 = $1,100 of tax savings based on differences in assumed current versus future income levels

Based on the example above, every $10K nets $1.1K with no additional effort, other than making use of RRSPs. That is a one-time return on investment that is difficult to beat, complemented by the expected growth of your RRSP investments over time.

No matter your risk tolerance, if you expect to earn a lower income than you do now once retired, reducing your tax burden by investing in tax-deferred accounts makes sense. This difference in taxation levels make RRSPs a reasonable investment vehicle, despite the restrictions associated with managing a tax-deferred account...as long as you reinvest the immediate tax savings! A tax return is not free money!!

But we're not done yet...

There's more to consider: employment income is the most expensive type of income you can make, for a few reasons:

• You incur the additional deductions, such as Employment Insurance and the Canadian Pension Plan.
• It is taxed at a higher rate than most other income
  • Only 50% of net capital gains are taxable and
  • Canadian dividends are taxed at approximately 13-14%, which is less than half the rate of the lowest employment income bracket!
• You literally have to work for it!

So why not focus savings beyond what you invest into RRSPs into having your money work for you now as opposed to the other way around? Seek opportunities to make passive investments and the rewards will go far beyond those of using tax-deferred accounts.

Once you have invested the appropriate amount into RRSPs in any given year, you can use additional savings to build the following accounts:

• TFSA: The Tax Free Savings Account allows you to build a portfolio that can grow without  future tax implications. This is a wonderful way to invest in assets and allow them to grow  without having the headache of determining the tax implications of various investments.
• Investment account(s): Once your TFSA is at capacity, additional after tax dollar savings should be directed toward investments that focus on building passive income streams over time. My preference is for income streams that:

1. Are straightforward and easy to understand. If I don't understand the investment, how do I know it's the right place to put my money?
2. Do not make my eyes roll back at tax time. If I pay more in accounting fees, or in personal time and effort, than the additional return I made because of an investment choice that makes taxes payable difficult to decipher, what was the benefit of selecting that investment? Not worth it!

Based on the above, dividend-paying stocks, and sometimes bonds, are a preference of mine, depending on the return and the level of risk involved. Solid, dependable companies and organizations are strong candidates, but whatever you choose has to make sense for you. The benefits of passive income are significant: reduced dependence on earned income over time, lower tax implications on each dollar earned and, most importantly, peace of mind.

Bottom line: save your hard-earned dollars and use the vehicles at your disposal to:

• Pay your fair share of taxes but not a penny more by taking advantage of:
  • Tax-deferred and
  • Tax-sheltered accounts.
• Invest after-tax dollars to build passive income streams, preferably with little need for a hands on approach.

I wish you the best as you work through yet another tax season. May your taxes be low and your savings plentiful!

How do get ready for tax time? Do you have tax and investment tips to share?

Notes:

*Based on income tax levels for Manitoba, Canada 2013.

**When you are ready to withdraw some RRSP funds in the future, say $30K per year at 26% taxation = you have netted $2K for every $10K*** invested without even lifting a finger. That is a 20% guaranteed return on investment, not including the returns associated with compounding interest. Pretty significant, wouldn't you say?

***Assuming a mid-point in taxation, will change depending on your income level and income tax brackets at time of withdrawal.