Good timing, for once

I've bragged in the past about my market timing acumen, which tends to favour the party sitting opposite me in any transaction. I tend to dwell on my past decisions, but only to the point of nodding sadly in lament of my knack for choosing the wrong time to pull the trigger. These decisions don't consume me, but I can easily count them off for you on a moment's notice.

Not this time, however.

The Loonie household mortgage was up for renewal last month, so Ms. Loonie and I checked out the rates available to us. We were able to renew with our current lender for a 3-year fixed rate of 2.65%, more than 2% lower than our previous rate. The day after we signed the papers, rates jumped by 50 basis points, so we literally slid in just under the wire, and guaranteed ourselves three years of low-rate home ownership. I'm sure a strong negotiator with excellent credit could still have secured a lower rate, but given the ease of the transaction, I'm pretty confident in saying that we locked in "at the bottom".

But that's not all. Since I was at the branch anyway, I decided I would talk to the bank about managing our own property tax payments. Since our mortgage is high-ratio (more than 80% loan-to-value), the bank has been collecting property tax payments from us, and paying the city on our behalf. Now that we've mastered the art of partitioning our savings, we decided that we'd rather pay the city directly, and have more control over the balance in this account (and hey, why not earn some interest on it while we're at it?). This change turned out to be very straightforward as well. The tax portion of our bi-weekly mortgage payment has been eliminated, and I've set up a bi-weekly transfer of the appropriate amount to a dedicated savings account.

We're now making much faster progress on the mortgage, and we're in control of our property tax payments. Easy as pie, right?

Until I realize that, as a side-effect of the CUPE strike currently underway in the GTA, there's nobody manning the phones in the city revenue office to take our lender off the tax account.

Great timing.

Taking the road less optimized

I'm a numbers guy.

I love numbers. I actually enjoy working with spreadsheets, and I love the challenge of working out the mathematically optimal way of doing things. Flexo at Consumerism Commentary has a great post today on the power of a "mathematically correct" solution, and I have to say I agree with his logic.

That doesn't mean, however, that I always use the optimal solution.

Take my bi-weekly cash flow, for example:

1. Money comes into our joint chequing account on payday


2. Fixed expenses, including mortgage payment, student loan payment and line of credit payment, come out of chequing


3. Emergency Fund and Freedom Account contributions are transferred from chequing to online savings


4. Leftover cash gets transferred into my secondary chequing account, as my spending money for the next two weeks


5. As I spend money on groceries, entertainment, etc., I either pay cash, or use my credit card and immediately transfer the corresponding amount from chequing to my line of credit


6. When my credit card payment is due, I pay the bill with my line of credit

Steps 5 and 6 are my attempt to perform small-scale credit card arbitrage with my monthly spending. Because the credit card is paid in full every month, each purchase essentially represents an interest-free loan until the next payment due date. By making a corresponding interim payment to my line of credit, I'm actually using my credit card to defer interest accrual on the LOC, and saving myself some money.

I'm pretty proud of having devised this system, but I can't ignore the fact that, if I skipped steps 4 and 5, and instead just transferred all my leftover cash onto my LOC on payday, I would save even more interest. Even though this might be the "right" way to structure my cash flow, I've learned from experience that it's much easier to lose track this way than it is with the method described above. I find that transferring funds every time I make a purchase gives me a much more concrete feel for how much I've spent, and how much I have left before the next payday. The extra interest that I accrue by leaving that money sitting in the chequing account ends up being the "fee" that I pay for having a system that works for me.

True, I could be paying less interest, but I could also be paying a lot more, and I'm happy to find some middle ground.

This is partly about having training wheels on our financial bicycle, but it's also about priorities. I keep $200 of my Emergency Fund in physical $20 bills, earning no interest, so that we have cash immediately available in an emergency. Both Ms. Loonie and I have income tax withheld by our employer so that we don't have to worry about making up a shortfall at the end of the year, and also to keep us thinking of our income in net, rather than gross terms.

As the size of our Emergency Fund grows, it will become more important to optimize the vehicles we use for these savings. Similarly, as the gap between income and expenses grows, the impact of where I keep my "in-flight" cash will become more significant. However, for now, I think the small dollar amount we give up in order to have a convenient, manageable system is worth it.

Starting a new career: changes for Ms. Loonie

I've mentioned a few times that Ms. Loonie has a new job. Today is her third day at her new employer, and so far she is very happy with her decision. She's in a very collaborative environment, and the work seems, even at this early stage, to be engaging and challenging.

There's also the minor matter of a 67% pay increase, but let's not dwell on small details.

With the new job, there are a few changes that have to be managed:

• Transportation - Her office is a half-hour subway ride away. Previously, we were both able to walk to work, so this represents an added monthly expense, in addition to the extra time spent commuting. We've budgeted for a monthly TTC Metropass, which is cheaper than purchasing the equivalent number of tokens, and also provides a tax credit.


• Clothing - The dress code in her new office is more professional than what she is used to. This means that, for the first time, she needs to have a selection of "work" clothes to wear. She and I may not quite see eye-to-eye on whether this is a pro or a con, but either way, we have a new expense to maintain her business wardrobe.


• Pay schedule - As I mentioned previously, her new employer is on a twice-a-month pay schedule, as opposed to her previous bi-weekly system. This means that each paycheque represents 1/24 of her annual take-home pay, so she ends up being paid slightly more per pay, but on a less frequent basis. We need to make sure that we can cover our fixed bi-weekly expenses during mis-matched pay periods. On July 10, our mortgage and student loan payments will be debited from our joint account five days before her July payday, so this will be our first trial.


• New payroll deductions - Not only has her salary increased, but the type of income she earns has changed. She was previously paid from a variety of research fellowships, and she is now earning employment income. This means that she will have income tax withheld, in addition to paying CPP contributions and EI premiums. She's actually quite excited to start paying into CPP and EI "like a grown-up".


• Better benefits - Her new employer has a good defined-benefit pension plan in addition to strong health benefits. We'll have to have a long look at our respective benefit plans in order to determine how to allocate our coverage.


• Tax withholding - although her new employer withholds income tax, her previous income was not taxed at source, so she will likely have a tax bill to pay come April 2009. After that, however, she should be able to enjoy some nice tax refunds in future years.

We're both very excited about this career change. It's an exciting opportunity, and has a number of strong financial benefits. I can't wait to see how we navigate the transition period, and what sort of long-term change this represents for the Loonie household.

Feeling some property tax relief

Both Paid Twice and Make Your Nut posted recently about changes to their property tax payments. Like many new homeowners, they make escrow payments to their mortgage lender in order to cover their periodic property tax expenses, and like many new homeowners, they started off with an escrow shortage, and subsequently saw their payments jump to cover the shortfall.

Ms. Loonie and I have been in a very similar situation. We make a property tax payment to our bank every two weeks along with our mortgage payment, and this is meant to cover our property tax bill when it arrives. Because we had a tax bill to pay shortly after closing on our condo, we initially found ourselves behind on our tax payments, and the bank hiked our bi-weekly contribution as a result. Now that we've got two years of payments under our belt, however, we're finally getting caught up on our initial shortfall, and I've been thinking of talking to the bank to get the payments adjusted back down.

Well, it turns out the adjustment letter we received last summer was just part of an automatic review the bank does on the account every year, as we received an almost identical letter from them this year. The only difference is, this time around the payments are being reduced rather than increased.

It's nice to see that the bank is actually proactive with managing the property tax account. I'd still prefer to pay the taxes ourselves (and I think we'll look into this when we renegotiate next summer), but it was a nice surprise to see the lender adjust our payments down without having to ask.

Like Paid Twice and Make Your Nut, we'll have a bit of extra cash injected into the budget once the payments readjust (effective August 21). It amounts to about $100 per month for us, which is certainly welcome. This was a nice instance of seeing something I read on a couple of American blogs relate directly to my own situation here in Canada. Another illustration that, although the terminology may differ, our financial systems operate in very similar ways on either side of the border.

Enter the TFSA

Checking my account balances online this weekend, I noticed a link on ING's front page to information on the Tax Free Savings Account that will make its debut in Canada in 2009. The folks at ING have included a top-10 FAQ on the TFSA, and their tagline for the product, "Great news. Now even the Government wants you to save your money!" illustrates the reason I love this company: they want to get people excited about saving.

I'm not so naïve that I can't see ING's financial motivation here (I do work in the banking industry, after all), but they really seem to put a lot of effort into making these saving products attractive to the consumer. I personally consider opening an ING account one of the most important steps I took to start my financial turn-around last spring. Saving for saving's sake was something new to me, and I have to say they've got me hooked.

One of my favourite things about ING is the way their products "cooperate" with accounts at other institutions. It's dead simple to move funds between your brick-and-mortar accounts and your ING account, and this gives their products a clear place in your financial portfolio. Their focus (at least in Canada) is not on meeting your chequing and day-to-day spending needs, but they do a great job at providing a convenient savings product.

ING is the first bank I've seen openly promoting the TFSA, and I can't wait to see when and how the other institutions start to promote their own accounts.

Start getting your 2008 taxes ready today

With less than a week to go, many Canadians are scrambling to complete their 2007 tax returns befor the April 30 deadline. Million Dollar Journey is among these last-minute folks, and he has a great post today on keeping your paperwork organized to make tax season as painless as possible.

It would be easy to dismiss this kind of tip by simply saying "OK, I get it, I need to get more organized!" However, let's not forget the core piece of advice here: the best way to be organized a year from now is to get organized today.

Taxes are a fantastic example of something that happens at the same time every year, yet somehow manages to find a large section of the population completely unprepared. Whether they don't have their paperwork in order, or don't have the cash on hand to pay their tax bill, lots of people seem to be caught by surprise by their taxes. With some planning and some basic organization, this can be avoided.

Another example of this is Christmas shopping. Christmas falls on December 25^th every year, but there always seems to be a last-minute scramble to buy the presents (usually on credit). Last year, I started saving for my Christmas purchases at the beginning of May, and I was able to pay for all my gifts with cash. This year, I've been saving since January, which should give me even more breathing room when the holiday season arrives.

It can be hard to force yourself into thinking so far ahead, but once you make the initial time investment to put the plan in place, it should save you having to think about it when tax time comes around next year. In 2008, I need to start repayments to my RRSP under the HBP and LLP, which means that, with my projected income and deductions for the year, I'll owe about $1,000 in taxes. Starting with my next paycheque, I'm contributing $40 every two weeks to my Freedom Account, specifically so I can cover this tax liability. Knowing I've planned for this will save me lots of stress a year from now, and I should be able to pay the bill without missing a beat.

There's really no better time than today to start planning for next year's taxes. Well, maybe six months ago would have been better, but today's certainly better than next April.

Weekly Wednesday weigh-in: Tax deadline coming up

Today's weigh-in once again showed no forward progress. I'm holding steady at 207lbs, which is frustrating but not surprising. I've really been watching the caloric intake side of things, but I haven't been as successful as I would like with keeping up my exercise schedule. By walking to and from work, I'm getting an hour of walking nearly every day, but what I really need to do is get down to the gym and/or squash court on a regular basis. If I can get into this schedule, then I should really start to see some consistent progress.

For those of you who haven't filed yet, next Wednesday is the deadline for filing your 2007 taxes if you owe. This time last year, I was forking over $1,500 from my line of credit to the CRA, and panicking about how I would ever pay it off. This year, I was able to put $500 of my tax refund toward debt reduction, above and beyond my regular bi-weekly payments.

Guess which one of those scenarios made me a happier camper?

Claiming the tax credit for charitable donations

Canadians can generally receive a non-refundable tax credit for charitable donations up to 75% of their net income (i.e. income minus deductions). I wrote a long post last month on the calculation of Canadian income tax, and in this post I mentioned that, for couples filing jointly, charitable donations should be pooled onto a single tax return.

The reason for this is that the first $200 of donations that you claim generate a credit at the lowest marginal tax rate (21.05% in Ontario for 2007), while anything over $200 is credited at the highest rate (40.16% in Ontario for 2007). If a husband and wife each donated $300 to an eligible charity this year, and claimed the donations individually, then each person would receive a 21.05% credit on the first $200, and a 40.16% credit on the last $100, for a total credit of $42.10 + $40.16 = $82.26 each. If, on the other hand, the entire $600 were claimed on a single return, then the the total credit would be $42.10 + $160.64 = $202.74, or $101.37 each. That's $38.22 in extra tax savings for the couple, just for claiming the donations jointly.

Until recently, I was under the impression that it doesn't matter which return you claim the taxes on, provided both returns have taxes against which to apply the credit. However, as I discovered while going over our own taxes last week, it does make a difference. The main reason for this is the provincial surtax, which is added if your provincial taxes owing are over a certain amount. In Ontario, for 2007, the surtax is 20% on taxes between $4,101.01 and $5,172, and 56% on taxes over $5,172. Because the surtax is calculated after applying any credits, the benefit of a tax credit is greater for taxpayers in higher provincial income brackets.

If your Ontario taxes (before credits and surtax) come to $4,000, then a $1 provincial credit saves you $1 in taxes, since you are below the surtax limit. However, at $5,000, your $1 credit saves you $1.20, and at $6,000, it saves you $1.56. For the $600 donation example above, the $202.74 credit is made up of $146.00 federal and $56.74 provincial. This means that someone with $4,000 in provincial taxes would save $56.74, while someone paying $6,000 would save $88.51. Clearly, it makes sense for the donations to be claimed by the person with higher total taxes.

By claiming our $1,300 in 2007 donations on my own return instead of Ms. Loonie's return, we end up saving an extra $75 in taxes as a couple. That's $75 that we can divvy up between us however we want.

Who are we to turn down free money?

Getting the most from a group RRSP

Canadian Capitalist has a nice post on the benefits of participating in an employer group RRSP. The gist is that, if your employer provides a match to your contributions, then you are leaving money on the table by not signing up for the plan. Many personal finance experts list this as a priority even while paying off debt: contribute enough to your employer's retirement plan (group RRSP for Canadians; 401(k) for Americans) to get the maximum employer match.

My employer has a group RRSP in which they match half of employee contributions, up to an annual maximum. In my case, the employer match is only available for purchases of the company stock. We also have a portfolio of low-MER mutual funds that we can contribute to through payroll deductions, but there is no match on these funds. Still, having an immediate return of 50% on my investment every two weeks is a great deal, even if it is all invested in my employer's stock. Unless the value of the stock suddenly drops by more than 30%, I end up ahead.

One of the benefits given by Canadian Capitalist is the up-front tax refund you get if you contribute to your employer's group RRSP through payroll deduction. Because you're making the RRSP contribution directly from your paycheque, your employer withholds less income tax, so the impact of the deduction is lessened. Plus, you aren't making the dreaded interest-free loan to the government.

Of course, this up-front tax refund also means you aren't in for a juicy refund cheque when you file your taxes in the spring, because you've already realized the tax savings. The RRSP advertising through January and February of every year is counting on the appeal of a big tax refund resulting from a lump-sum contribution to bring your money through the bank's door. However, if you've been contributing a portion of each paycheque all year long, you may not have this lump sum available.

There is a way you can "trick" yourself into giving yourself a refund for your group RRSP contributions. If you multiply your paycheque deduction by your marginal rate, and set up a recurring transfer of the resulting amount to an online savings account, then when tax season comes around, you will have a virtual tax refund sitting in this account.

For example, if you contribute $150 every two weeks to your employer's group RRSP, and your marginal tax rate is 40%, then you would set up a bi-weekly transfer of $60 to an online savings account. At the end of the year, not only will you have $3,900 (plus applicable employer match) in your RRSP, but you'll have $1,560 sitting in a savings account, as your reward for saving so well.

Making sense of income tax

With February out of the way, and the associated deluge of RRSP advertising put to rest for another year, it's time for the push to get your tax return filed. Canadians have until April 30 to file their tax return, and this is the time of year when we traditionally shove a pile of paperwork at our accountant, and hope for the best.

Although there can be a lot of number crunching involved, preparing a personal tax return can actually be pretty straightforward. I thought I'd post a general summary of the calculation of Canadian income tax.

The Basics - Marginal vs. Average Tax Rate

At its most basic, income tax represents a percentage of the income that you make in a year. If you divide your total income tax for the year by your total income for the year, you get your average tax rate. You will rarely see two people with the same average tax rate, unless they have exactly the same income. This is because income tax is actually calculated as a percentage of marginal income earned within tax brackets. For 2007, the federal tax brackets and marginal tax rates were as follows:

• $0.01 - $37,178.00 - 15% tax


• $37,178.01 - $74,357.00 - 22% tax


• $74,357.01 - $120,887.00 - 26% tax


• $120,887.01 and above - 29% tax

Therefore, if you had income of $40,000, you would pay 15% on the first $37,178 ($5,576.70), and 22% on the next $2,822 ($620.84), for a total of $6,197.54 in federal tax, giving an average federal tax rate of 15.5%.

Each province has its own marginal tax rates, which are calculated on top of federal taxes. In Ontario, for example, the 2007 provincial brackets were as follows:

• $0.01 - $35,488 - 6.05% tax


• $35,488.01 - $70,976.00 - 9.15% tax


• $70,976.01 and above - 11.16% tax

Therefore, if you had income of $40,000, you would pay 6.05% on the first $35,488 ($2,147.02), and 9.15% on the next $4,512 ($412.85), for a total of $2,559.87 in provincial tax, giving an average provincial tax rate of 6.4%.

That's the basic method of calculating income tax. Here is the CRA's list of 2007 tax rates.

Now we can get into some of the other factors that affect your income tax.

Income

Not all income is created equal. Employment income is fully taxable, while scholarship income for post-secondary students is entirely tax-free, and investment income has special tax rules. For a full breakdown of the treatment of various income sources, refer to the CRA's guide to total income for 2007.

Deductions

Deductions reduce the income on which you must pay taxes. You could say that tax deductions come off the "top" of your income, so you end up paying less tax in your top tax bracket. For example, if someone has $40,000 in income and claims a $1,000 deduction, then their taxable income drops from $40,000 to $39,000. This means that the amount of income taxed at a federal rate of 22% drops from $2,822 to $1,822, for a tax savings of $220. Compare this to someone earning $35,000, who also claims a $1,000 deduction: their federal tax savings will be only $150.

In general, tax deductions favour higher earners, since the tax savings happen in a higher tax bracket.

Examples of tax deductions are RRSP contributions, union dues, and job-related moving expenses. For a full list, refer to the CRA's list of 2007 federal deductions.

Non-refundable Tax Credits

Whereas tax deductions come off the "top" of your income, credits come off the "bottom", meaning they represent a tax savings in your lowest tax bracket. Take, for example, our $40,000 and $35,000 earners from above. If each of them claims a $1,000 federal tax credit, then they will each save $150 in federal taxes.

The "non-refundable" nature of the tax credits simply means that these credits can only be used to offset taxes owing; if you owe $100 in taxes without any credits, and claim a $1,000 credit, you will owe $0 in taxes, as opposed to being owed $50 by the government. In most cases this extra $50 can be carried over to the next tax year.

Tax credits are considered more equitable than deductions, since they do not favour high-income taxpayers over low-income individuals.

Examples of non-refundable tax credits are the Basic Personal Amount, the Canada Employment Amount, and CPP and EI contributions. For a full list, refer to the CRA's list of 2007 federal credits.

Charitable Donations

Charitable donations are treated as a tax credit, but there's a slight twist. The first $200 of donations in a given year generate a credit in your lowest bracket, and any amount above $200 generates a credit in the highest bracket (regardless of whether you have income in that bracket). This means that a donation of $300 would translate to a $200 federal credit at 15%, and a $100 credit at 29% regardless of your income.

If you are filing jointly with your spouse, you can (and should) pool your donations together on one return. If each spouse makes a $300 donation and claims it individually, then each spouse will have a federal tax savings of $59 (15% of $200 plus 29% of $100), for a household total of $118. Compare this to one spouse claiming $600 in donations, for a federal tax savings of $146 (15% of $200 plus 29% of $400). Similarly, if you plan to donate $300 this year and next year, it may be more beneficial to wait until next year to claim this year's donations. The idea is to minimize the number of "transactions" that are subject to the $200 threshold.

Other Taxes

Ontario residents pay a health premium, based on their income level, to subsidize health care. Several provinces, including Ontario, are also subject to a provincial surtax. For example, the 2007 Ontario surtax applies to provincial taxes as follows:

• $0.01 - $4,100.00 - 0% surtax


• $4,101.01 - $5,172 - 20% surtax


• $5,172.01 and over - 56% surtax

Note that the surtax is applied to the provincial taxes owing, not to taxable income. If an individual owes $6,000 in Ontario taxes, then their surtax will be 20% of $1,072 ($214.40) and 56% of $828 ($463.68) for a total surtax of $678.08.

A good rundown of all the provinces' applicable taxes is provided at Taxtips.ca.

Pulling It All Together

That's a lot of material to digest, so let's bring everything together with an example. I'm most familiar with Ontario taxation, living as I do in Toronto, so this will be an Ontario-centric example.

Particulars

• Employment income: $50,000.00


• RRSP contributions: $5,000.00


• Charitable donations: $500.00


• Income tax withheld by employer: $9,500.00


• CPP contributions paid: $1,989.90


• EI premiums paid: $720.00


• No "special" credits apply

First, let's calculate our friend's taxable income. The $5,000 RRSP deduction takes total taxable income down to $45,000. This is the amount that is subject to federal and provincial taxes. The taxes owing would be calculated as follows:

Federal Tax

• 15% of $37,178 = $5,576.70


• 22% of $7,822 = $1,720.84


• Total federal tax = $7,297.54

Ontario Tax

• 6.05% of $35,488 = $2,147.02


• 9.15% of $9,512 = $870.35


• Total Ontario tax = $3,017.37

This gives us the gross federal and provincial income tax amounts. Now, let's determine the non-refundable tax credits:

Federal Non-Refundable Tax Credits

• Basic Personal Amount = $9,600


• Canada Employment Amount = $1,000


• CPP Contributions = $1,989.90


• EI Premiums = $720.00


• Total federal credits = 15% of $13,309.90 = $1,996.49

Ontario Non-Refundable Tax Credits

• Basic Personal Amount = $8,553


• CPP Contributions = $1,989.90


• EI Premiums = $720.00


• Total Ontario credits = 6.05% of $11,262.90 = $681.41

Now factor in the charitable donations:

Federal Tax Credit

• 15% of $200 = $30


• 29% of $300 = $87


• Total federal credit = $117

Ontario Tax Credit

• 6.05% of $200 = $12.10


• 11.16% of $300 = $33.48


• Total Ontario credit = $45.58

Now determine the net taxes owing:

Federal Tax

• Gross income tax = $7,297.54


• Non-refundable tax credits = $1,996.49


• Charitable donation credit = $117.00


• Net federal tax = $5,184.06

Ontario Tax

• Gross income tax = $3,017.37


• Non-refundable tax credits = $681.41


• Charitable donation credit = $45.58


• Net Ontario tax = $2,290.39

Since the net Ontario tax is below $4,100, there is no applicable surtax. This individual's taxable income is $45,000, which translates to a $450 Ontario health premium. Therefore, the total taxes owing are as follows:

• Net federal tax = $5,184.06


• Net Ontario tax = $2,290.39


• Ontario health premium = $450.00


• Total tax payable = $7,924.44

This individual owes $7,924.44 in taxes for the year. However, because the employer has already withheld $9,500 in income taxes, there will be a tax refund of $1,575.56.

That's the basic nuts and bolts of how taxes are calculated in Canada. There are, of course, more complicated situations, for which a tax professional should be consulted. At the very least, however, this guide should help you to estimate your own return, so you know roughly what to expect.

Changes coming to RESPs?

This week, the House of Commons passed a bill that would provide a tax deduction for RESP contributions. The bill still needs to be approved by the senate, but it's an interesting idea.

Currently, RESP contributions are made with after-tax dollars, and compound tax-free until they are withdrawn by the beneficiary for post-secondary education purposes. At withdrawal, the investment income is taxed to the beneficiary, at their (usually low) marginal rate. Under the proposed bill, up to $5,000 in annual contributions would qualify for a tax deduction, similar to RRSP contributions. This would represent a fundamental change in the tax treatment of these plans, and potentially provide a much greater incentive for parents to contribute to their children's plans.

I've written before about the benefits of contributing to RESPs, essentially looking at this plan as a sort of "education insurance", but this new bill would significantly change some of the assumptions. Let's look at a simple example to determine what the impact of this change might be:

Assumptions

• One-time RESP contribution of $5,000


• CESG match of $500


• Contributor marginal tax rate = 43.41%


• Beneficiary marginal tax rate = 22.15%


• Investment growth = 8%


• Inflation = 3%


• 18 year investment period

The $5,000 contribution would generate an immediate tax savings of $2,170.50 for the contributor. In future dollars (i.e. after 18 years' inflation at 3%), this would be $3,695.13. The $5,500 (contribution plus CESG match) would grow to $21,978.11 after 18 years of 8% growth. Assuming that the beneficiary withdrew this entire amount for education purposes at the 18 year mark, they would pay $4,868.15 in taxes (since taxes would presumably be paid on both the contribution and the investment income). This represents $1,173.02 in net taxes paid (i.e. taxes paid by the beneficiary minus taxes saved by the contributor).

Compare this with the current rules, where the beneficiary would pay tax only on the $16,478.11 investment income, for a net taxation of $3,649.9 (since the contributor does not have any up-front tax savings). This is $2,476.88 more than the taxes paid under the proposed system.

Based on this example, it seems that the proposed tax deduction would result in a much more tax-efficient way to save for education, especially if the contributor were to put the $2,170.50 tax refund in a TFSA for some additional tax-free growth.

What do you think about this idea? Have I missed anything?

Another nice tax surprise

After last week's realization that Ms. Loonie would owe $2,500 less than expected on her 2007 tax return, I've been on the lookout for other hidden gems in the income tax rules.

Well, faithful reader, you will be delighted to learn that I've found another unexpected tax credit for which I (and many other Canadians) will qualify: the Canada employment amount. This is a federal non-refundable tax credit for taxpayers who received employment income for the year. You can claim the lesser of $1,000 or your total employment income (lines 101 and 104 of your tax return).

I earned just a smidge over $1,000 in 2007, so I'll be claiming the full $1,000 credit. At a tax rate of 15%, this translates to an additional $150 in my pocket.

Given that I stopped commuting to work just after the public transit amount came into effect, it's nice to have one of these new credits actually apply to me.

Who doesn't love finding $150?

The clouds part

I've written before that Ms. Loonie does not have taxes withheld from her paycheque. Instead, she uses an ING Direct account to save up her tax payment. This will be the first tax season to test this system (until this past year, she's always had taxes withheld), so I was crunching some numbers yesterday to determine where the ING balance stands relative to her estimated taxes owing.

Ms. Loonie is a post-doctoral researcher, and as such is paid under a fellowship grant. Other than the first $500, this grant income is not tax-free, because she doesn't qualify for the educational amount (she's no longer a student). Because the income is taxed, I've been treating it as regular employment income in my calculations, with the associated CPP and EI contribution requirements.

It occurred to me yesterday, however, while looking over her T4A forms (the official CRA form to document pension, annuity and other income), that CPP and EI do not apply to her income. This effectively reduces her taxes owing by more than $2,500!

After making the appropriate adjustments, it looks like she will have more than enough saved up to cover her tax bill. That's great news, but the even better news is that she started late last year with her ING savings (she made her first contribution in late August, giving her only eight months to save up for her April 30 payment), so with a full year to save up for her 2008 bill, she can actually adjust her contribution amount, diverting 25% to build up her own cushion of savings.

I've been dreading tax season this year, worried about whether we'd have enough to cover her bill, so with this sudden realization, a huge weight seems to have lifted.

This is a good day.

Happy Bissextile Day!

Now, before you all jump on me, saying that Bissextile Day is in June, I'm talking about the extra day that gets added in a Leap Year. Apparently, in the Julian Calendar, this extra day was initially an extension of the "sixth day before the calends of March", resulting in a "sixth day" that was twice as long as usual, thus the "bissextile", or "twice sixth" day. Phew. That's a lot of quotes and calendrical conventions.

Anyway, if you haven't done so already, today is your last chance to make a 2007 RRSP contribution (you can make a contribution tomorrow, but it can't be counted as a deduction on your 2007 tax return). If you're planning to make an in-branch contribution today, then expect some line-ups: today is the RRSP deadline and a Friday and the last day of the month, so banks will be just a bit busy.

Enjoy...

Early RRSP withdrawals

I seem to have savings and taxes on the brain. I'm not sure whether this is because of yesterday's budget announcement, or Friday's RRSP contribution deadline. Either way, if you've been conscious at any point this month, you've probably been urged by someone to throw those piles of extra cash you have lying around into your RRSP.

While everyone's talking about getting money into RRSPs, I thought I'd look at the ways it's possible to take out your RRSP savings before retirement. Specifically, the HBP and LLP offer a way to do this when buying your first home, or pursuing post-secondary education, respectively.

Home Buyer's Plan

If you are a first-time home buyer, you can withdraw up to $20,000 from your RRSP, with no tax penalty, provided this money goes toward the purchase of a home within a specified time frame. You then have fifteen years to pay this money back in annual instalments into your RRSP. If you miss a year of catch-up contributions, then the amount of missed contributions is added to your taxable income, and taxed at your marginal rate.

Example

Suppose you withdraw $15,000 for a down payment under the HBP. You will then be required to pay back $1,000 per year to make up for the withdrawal over the next 15 years. If you miss a year, then $1,000 will be added to that year's taxable income.

You can look at this withdrawal as a loan you make to yourself from your retirement savings. There is no interest on this loan, except for the lost compounding on the funds you withdrew. If you withdraw $20,000 and pay it back over 15 years, then the value of those funds will be less than $20,000 in today's dollars. Hopefully you will make up the difference in home equity, but this is far from guaranteed.

Read more details on the HBP here.

Lifelong Learning Plan

If you are (or your spouse is) enrolled in (or planning to enrol in) post-secondary education, then you can withdraw up to $10,000 per year (up to a plan limit of $20,000) from your RRSP to cover educational expenses. You then have 10 years to pay this money back into your RRSP. As with the HBP, any missed catch-up contributions will be added to your taxable income.

Read more details on the LLP here.

Repayment

To pay back a withdrawal under either of these plans, you must complete Schedule 7, and include this with your tax return. The Schedule 7 designates a portion of your annual RRSP contributions as repayments to the HBP or LLP. These designated contributions will then not be included as deductions on your tax return.

Example

Suppose you have withdrawn $15,000 under the HBP, and make two RRSP contributions, one for $1,000 and one for $5,000. You would use Schedule 7 to designate $1,000 as an HBP repayment, and only the $5,000 would be included as a deduction on your tax return, even though you technically contributed $6,000 to your RRSP.

Note that the net tax consequence of making the $1,000 repayment and another $5,000 in RRSP contributions is to reduce your taxable income for the year by $5,000. This could also be accomplished by claiming the entire $6,000 as a deduction, and "missing" the $1,000 repayment: you would reduce taxable income by $6,000 for the contribution, and then increase it by $1,000 for the missed repayment.

Unless it bothers you to be "in arrears" on your repayments (to yourself), there doesn't seem to be much reason to claim a formal repayment on your tax return. The key is to ensure that your total RRSP contributions each year of your repayment period are greater than your required repayment amount.

Tax Free Savings Account: a Roth account for Canadians?

Wow, a lot can change when you spend a week on the couch. The federal government released the 2008 budget yesterday, and the news on everyone's lips (well, maybe not everyone, but at least on most Canadian PF bloggers' lips) is the creation of a new tax-advantaged savings plan, the TFSA. I hate to be a day late and a dollar short, but I can't go without commenting on this.

I've written before about the savings plans available in Canada and the US, and where the RRSP has a close cousin in the IRA, and the RESP is analogous to the 529 plan, the one savings vehicle unique to the United States is the Roth IRA. While the IRA (like the RRSP) is funded with pre-tax dollars, and withdrawals at retirement are fully taxed at the marginal rate, the Roth IRA is funded with after-tax dollars, and withdrawals at retirement are not taxed.

Well, the Roth account seems to have a new cousin (by marriage) in the proposed TFSA. Although not designated as a retirement account, the workings of the TFSA seem comparable to those of the Roth IRA: you can contribute up to $5,000 per year to a TFSA, and the income you earn in the account is not taxed. You can withdraw from the account at any time without penalty, and doing so actually frees up your contribution room again, so you can "re-fill" the account.

I'm finding it very difficult to find a downside here. The TFSA seems to be the ideal place for Canadians to keep their Emergency Funds. There's obviously a lot to be worked out here. I'm not sure what investments can be held in a TFSA, and what sort of interest rates will be paid on "cash" investments, but it sounds like a fantastic idea.

And it's nice to tie up a loose end by finding a dancing partner for the Roth account.

RRSPs and tax withholding

As we near the February 29 RRSP deadline, lots of posts are popping up regarding RRSP contribution strategies. Million Dollar Journey has an interesting post that derives a formula for calculating an appropriate RRSP loan amount. He recommends a target loan amount that is equal to (or less than) the total tax refund that would result. This means that, once you receive your tax refund, you can immediately pay off your loan in full.

The nice thing about this approach is that it essentially allows you, if you have the contribution room, to use your 2007 tax refund as a 2007 RRSP contribution. In his example, where you already have $5,000 in 2007 contributions, with a 40% marginal rate, you will be expecting a $2,000 tax refund. By taking out a $3,333 loan, and using it to make a $3,333 contribution before February 29, your total tax refund will increase to $3,333 (the amount of the loan). You therefore have no new debt (since the refund and the loan cancel each other out), and you have $2,000 in new retirement savings (from contributing your original 2007 refund) plus an additional $1,333 that basically came out of "thin air". Best of all, this is a trick that you can repeat year after year. Leveraged investing at its best.

My employer has a less-than-intuitive approach to income tax withholding, mostly with respect to our year-end bonus. Any bonus for which we qualify is included in the first pay of the new year, rather than the last pay of the year. We have the option to defer up to 85% of the bonus into a group RRSP, and I've taken advantage of this option each of the past three years. This has an unexpected (at least to me) impact on tax withholding.

Take this year, for example. I deferred my bonus with a $6,000 RRSP contribution on January 10. This will be claimed as a deduction on my 2007 tax return, but my employer adjusts my tax withholding as if it were a 2008 deduction. Therefore, every year I need to match my previous year's contribution in order to avoid paying taxes (failing to do this last year landed me with a $1,400 tax bill).

It took me a while to wrap my head around this one, but now that I'm aware of it, it forms a crucial part of my RRSP contribution planning.

What are your RRSP or other tax planning tricks?

This month has 29 days

In addition to being an Olympic year, 2008 is a Leap Year. That means your savings accounts will earn an extra day's interest, but your debts will also accrue an extra day's interest. Most significantly, this year February has 29 days.

For those of you here in the Great White North, a Leap Year has a specific impact on tax planning. The deadline for RRSP contributions in a Leap Year is February 29, not March 1. This means that, if you make a contribution after February 29, it will be counted toward your 2008 (or later) taxes.

February 29 is a Friday, and will therefore be a very busy time in most bank branches you might choose to visit. Therefore, it's probably a good idea to set things in motion for any last-minute RRSP contributions before the 29^th, so that you don't find yourself late to the party.

Investing and Taxes

Until this year, I never really considered myself an investor. Even though I have been making bi-weekly contributions to an RRSP for the past seven years, I've only recently begun to think about how my investments are allocated, both across asset classes and across markets.

There are a couple of reasons for this:

• The Employee Savings Plan under which I make my regular contributions has a two-year vesting period. This means that, until you've been enrolled in the plan for two years, you have to leave your shares untouched, or else you forfeit the employer's matching contributions. As a result, I spent my first two years deliberately ignoring my ESP account, and this habit survived beyond the end of my vesting period.


• I'm in debt. This has automatically put me in the mindset of trying to reduce my debts, rather than grow my assets.

Because of my limited exposure to investing, I haven't had to deal with tax considerations around my investments, beyond declaring RRSP deductions on my tax return.

As I get my financial machine running more smoothly, I'm starting to see the light at the end of the tunnel, and am beginning to imagine myself having investments outside my RRSP. As a result, I need to wrap my head around the tax concerns faced by investors.

There are several ways to derive income from investments:

• Interest income from bonds, savings accounts, etc.


• Dividends paid to shareholders


• Capital gains from the sale of investments (stocks, rental property, etc.)

These three types of investment income are treated very differently from a tax point of view, and I thought I'd go into the details.

Interest Income

The first type of income has the simplest, but least favourable, tax treatment. Essentially, every dollar of interest that you earn is treated as regular income, and added directly to your taxable income for the year. This means that, if you have a marginal tax rate of 35%, and you earn $100 in interest, you will pay $35 in tax.

In Canada, interest paid on a mortgage for your primary residence is not tax-deductible. In general, interest paid on loans is only tax-deductible if the loan is used to buy investments. There is also a technique, known as the Smith Manoeuvre, which can convert your primary mortgage interest to tax-deductible status through leveraged investing.

Dividend Income

Dividends paid by Canadian corporations have a favourable tax treatment, although the formula for calculating dividend tax is quite convoluted.

Dividend income is "grossed up" by 45%, so that a $100 dividend adds $145 to your taxable income. If your marginal tax rate is 35%, then you pay $50.75 (35% of $145) on every $100 in dividend income. The flip-side, however, is the dividend tax credit. This is made up of a 27.5% credit at the federal level, as well as a provincial credit ranging from 8-18%. The Ontario dividend tax credit for 2008 is 10.15%, so the credit for a $100 dividend would come to $37.65. This means that the net tax on dividend income for our Ontario taxpayer at 35% would be $13.10. In low-income tax brackets, this net dividend tax can actually be negative, which can offset other taxes owed.

Capital Gains

A capital gain results from selling an investment from more than you initially paid for it. 50% of capital gains are added to your taxable income, so if your marginal rate is 35%, then you will pay $17.50 in taxes on every $100 in capital gains.

The nice thing about capital gains is that, with certain restrictions, they can be offset by capital losses (resulting from selling investments at a loss). So if our 35% taxpayer had a $200 capital gain and a $100 in capital loss, they would pay $17.50 on the $100 net capital gain.

Note that, just as mortgage interest on your primary residence is not tax-deductible, the sale of your primary residence does not result in a capital gain (or loss).

Diversified Income

Just as it's recommended to hold diverse investments to control risk, it's recommended to hold your income-generating investments in the most tax-efficient vehicle. Of the three types of income, interest is the least favourable, as seen below for an Ontario taxpayer with a 35% marginal rate:

• Interest: $35 tax per $100 income


• Dividends: $13.10 tax per $100 income


• Capital Gains: $17.50 tax per $100 income

For this reason, interest-generating investments should only (or at least primarily) be held in a tax-sheltered account like an RSP. Since income from an RSP at retirement is already fully taxed at the marginal rate, interest income is no less favourable than dividends or capital gains in this kind of account. In a taxable account, however, dividends are the most tax-efficient type of income, followed by capital gains, so a taxable account is an ideal place for dividend-paying stocks.

Federal income tax cuts

There's been a lot of talk about whether we would be seeing tax cuts with the fall fiscal update, and it's now official.

The following personal tax measures are being introduced:

• The federal basic personal amount (the maximum income you can make without paying any federal income tax) is being raised from $8,929 to $9,600, retroactive to January 1, 2007, and continuing through 2008. The limit will increase to $10,100 for 2009.


• The lowest personal income tax rate (paid on income between $9,600 and $37,178) is being reduced from 15.50% to 15.00%.


• The GST is being knocked down another point to 5%.

I'm excited about the income tax measures. Basically, if you make over $37,178, the change will save you $241.90 in income tax for 2007. The GST reduction will also be handy, although I now have to learn to calculate 13% tax in my head, just when I had 14% figured out!