With a little over two weeks to go before tax returns are due for Canadians I’m starting to hear a lot of grumbling over having to pay taxes. Paying taxes is inevitable for every Canadian. We’re probably the most taxed people on the face of the Earth with high income taxes and also extremely high sales taxes.
If there is anything in common with every Canadian when it comes to personal finances, it’s that they all hate taxes. Since we already pay so much tax, and I highly suggest you don’t cheat the government in taxes, is it bad that we have to even more pay taxes when we do our tax returns?
Pay Your Share
Unfortunately for every dollar we earn, we have to pay tax. That’s a fact of life almost anywhere in the world. The hardest part to fathom for Canadians is that the next dollar we earn always seems to get taxed more and more. That’s essentially true because Canada uses a marginal tax system.
Most people don’t understand this concept, but the premise behind it is if you make more money, the next dollar you earn is usually going to be taxed at a higher tax rate than the first dollar you earn. Still confused? See my post on how income taxes work.
Isn’t A Refund Good?
When it comes to your tax return in April, most people want a refund. People think getting a refund is good because the government is giving money back to you, but in fact they are just giving money back to you because you paid too much tax to begin with.
Think really hard why we get tax refunds. It’s not because the government is trying to give us a break, it’s because over the course of the year we do things that effectively reduce our earned income. This includes buying RRSPs, claiming tax credits for government sponsored programs, or perhaps donating to our favourite cause. When these deductions are taken into effect, it effectively lowers the amount of income you’ve earned during the year.
For instance, if you know you will make $70,000 during the year and you are going to have tax deductions then why not tell the government beforehand. You can do that with the personal tax credits form and give it to your employer. By filling out your deductions, it means that less tax is paid during the year. This means more money in your pocket every month rather than waiting for a tax refund.
If you’re self employed and don’t know how much you’ll earn, then why not just save up your money pay taxes when you do your tax return? It makes much more sense because you can put your money to work for you during the year. Even if it means you earn just 3% in a high interest savings account.
To have a “good” tax return, you want to be paying nothing and receiving nothing. That means you paid just the right amount of taxes during the previous year. My question to everyone that receives a refund is usually “Why are you so happy getting back money you could have had 12 months ago”?
When you do your tax returns and you find that you owe money to the government it’s not necessarily a bad thing. That just means that you earned more money than your normal salary. That’s the point of achieving financial independence. You want to be earning passive money outside of your normal job.
So it shouldn’t be a surprise that come tax time you might have to pay a little bit of tax on the income you earned on your investments. Most people think it’s bad to pay taxes, but they just don’t understand why they are paying it.
When you are working and employed, the employer is deducting payroll taxes on each paycheck. That means for regular Canadians, they should be paying just the right amount of taxes for the money they are earning. However, once you start earning money outside of work, like a side hustle, or money made through investments, that money is not taxed by the government.
This is why just before tax time in February and March, the banks send tax slips through the mail to our door, or email nowadays, that outlines just how much extra money you’ve earned that needs to be declared on your tax return. This extra income is a good thing. Interest and dividend income that is earned from our investments is what drives us towards financial independence. The problem of being a successful investor is that we need to pay taxes. This isn’t necessarily a bad thing. We want to be making money with our money.
Paying taxes on our investment income is like a first world problem. So many people don’t get to the point where they have this problem, so if you’re faced with a tax bill consider yourself special.
Lower Your Tax Bill
If you’re just starting to invest, then probably the tax bill isn’t too high on your investments, but once you start to seriously invest it’s a good idea to try to lower your tax bill as much as possible.
Like I wrote before, we don’t cheat the government. Never cheat the government. But to lower your taxes, it’s smart to invest inside tax sheltered accounts. This means for Canadians that are starting to invest, it’s a good idea to use your TFSA account or your RRSP account. Any interest or dividend income made in those accounts remain tax free.
This means that during tax return season, income earned in these accounts don’t have to be declared to the government. The only time income is taxed is when you remove money from your RRSP account. Unless you are retired, this shouldn’t be a problem. Removing money from a TFSA account at any point in time does not trigger any taxes as all gains in the account are tax free.
What this all means is that when you do your tax return over the next two weeks, don’t get disgruntled that you have to pay taxes. In fact, having to pay taxes means your investments are doing well. The interest and dividends that you collect is starting to add up!
In the next few posts, I’ll outline some really good tips on how to optimize your investments so you don’t get hit with a large tax bill in April. There are many good ways to defer taxes so you don’t have to pay them until you’re older or retired. Stay tuned.