Note that this section of the website is not particularly active; I hope to publish about one personal finance article per month.

Sunday, April 27, 2014

Book Review: Tax Planning For You And You Family

Tax treatment is an important driver of the returns on your portfolio. If you are implementing your personal finance plans yourself, you will need to understand the tax consequences. But even if you have professional advice, you should have a reasonable understanding of what is behind the advisors' recommendations. In order to do this, you will need some good resources explaining the tax system. In this article, I discuss "Tax Planning for You and Your Family  (2014)" by KPMG, which is aimed at Canadians. I start off with some introductory remarks for non-Canadian readers.


 Tax Planning Matters Before You Transact



Although getting help to fill out your tax forms may be useful and provide savings, this is not the focus of this article. Tax planning has to be done before you do a transaction; once you have reached the point of recording the transactions for tax purposes, it is too late to make a better choice.

The value of financial securities for you is driven by their tax treatment. For example, most bonds have a big disadvantage versus equities in tax treatment in Canada and the United States if you hold them outside a tax shelter. (In the United States, some municipal bonds can be held free of income tax, depending on where the owner lives. But this freedom from taxes is counterbalanced by lower yields than similarly risky corporate bonds.)

However, these trade-offs are driven by your personal tax situation. The problem with getting advice from sources like the internet is that it may not reflect your needs. People prefer reading simple rules of thumb, and so those simple rules of thumb dominate discussion. But if you do not analyse why that rule of thumb holds, you may end up taking substandard advice. For this reason, you probably need to look at more comprehensive sources of information, and you need to run the numbers yourself.

Given these issues (plus legal ones), I cannot give tax advice. But I can discuss general principles how you can look at your finances.

KPMG Book Review


The KPMG guide "Tax Planning For You and Your Family" is very similar to a guide that I read when I started studying finance. Although this and similar guides come out every year, you could get away with reading one that is slightly out-of-date, at least as long as it came out after the TFSA was introduced (more below). But you must keep in mind that the tax code is tweaked every year, so if you want to analyse your financial plans, you may need to update your numbers. The very detailed recommendations (e.g., what can be deducted as an expense) is something you may need to only worry about when you fill out your tax forms.

It is not a book that you need to read from cover-to-cover for your own personal needs, unless you have an extremely tax situation (you live in Québec, are self-employed and an employee during the year, you were an executor of an estate and then plan on dying before year end). If you are an advisor to other people, you would need a wider knowledge of the tax system. However, you may need a guide with more detailed information, as there are a number of subjects where the book merely points out that the situation is complicated, and that the person should seek professional advice. And since you are that professional, that's you.

If you just read the sections that matter to you, the book is relatively easy to follow. And if you have a more complicated problem, it gives the reference for more detailed information elsewhere, such as where more information on the topic is available on the Canada Revenue Agency web site.

In my case, I was mainly interested in the handling of taxes for self employment. There was a good coverage of the topic, such as what are the trade-offs involved in creating a corporation. There were other sections on things like the GST, and whether expenses are deductible.

The sections on investment were also well done, but I would raise one cautionary point. The book obviously focuses on tax treatment of securities. But you also need to take into account the other characteristics of the investments. For example, a preferred share has much better tax treatment outside of a tax shelter than a corporate bond. But this value from taxes may be incorporated as a lower yield, and preferred shares are riskier than corporate bonds. They are subordinate in a debt restructuring (default) of a corporation.

A Good Introduction To Personal Finance


Chapter One is a 14 page introduction to personal finance planning. It covers many topics of personal finance in a very short space. However, it is focused on the financial side, and not lifestyle decisions. For example, it says "So if you can buy a home, don't rent." This leaves open the question of what "afford" means. (And that is probably a home priced much less than what a bank is willing to lend to you, as I discuss here.)

Self Employment Versus Employees


The book points out that the tax situation for employees is very different than people who own their own business. Employees' incomes are well defined, and there are only a small number of things which can be deducted from that income.

If you run your own business, the tax situation can be much more complicated. In particular If you incorporate, you have two choices for income:

  1. pay yourself a wage; or
  2. pay yourself dividends.
Additionally, there is the question of what are business expenses that you can deduct. Historically, the system was fairly loose, but rules have been tightened, limiting what can be deducted legitimately.

This book is not aimed at people with extremely complicated tax situations. If you have a well developed business, you will probably need professional advice. But for something like a consulting business, the book covers the main topics adequately.


Tax Shelters - RRSP's, TFSA's, Etc,


For most people, the main decision you face in personal finance is deciding where you hold your assets. In most cases, the correct answer is to hold them in:
  • Tax-assisted retirement plans. Registered Retirement Savings Plans (RRSPs) and similar vehicles (pension plans).
  • Tax-assisted savings plans. The new Tax-Free Savings Account (TFSA), Registered Education Savings Plans (RESPs). 
The parameters of your pension plan depends on what your employer offers (often none), but you need to take it into account when looking at your overall situation.

The book devotes a couple chapters to this very important topic, and has a discussion of which vehicle makes the most sense. But the key point to remember is that RRSPs and TFSAs are not investments, they are places where investments are held. Contributing to a RRSP is not enough to meet retirement needs; the contributed money needs to grow.

I will discuss taxes and RRSPs in an upcoming article, so I will not discuss the details further.

Tax Splitting


The Canadian tax system is progressive - as the amount you earn grows, it goes into brackets with higher tax rates. If you are married, your combined tax situation is improved if you and your spouse end up equalising your incomes so that you end up in the tax bracket. For example, a couple earning $50,000 each pay less tax than a couple with only one spouse working and earning $100,000.

There are very few ways of legally redistributing income between family members, and the book covers them. One relatively new income splitting measure is the treatment of  pension payments, which now can be split to the lower income spouse.

Other Topics 


There are 22 chapters in the book, covering the whole range of personal tax planning. Other chapters include:
  • Investments.
  • Capital Gains and Losses.
  • Charitable donations.
  • How to deal with tax collectors (how to respond to audits, penalties, etc.).
  • Interactions with the U.S. (including if you are a U.S. citizen in Canada).
  • Retirement planning.
  • Estate planning, and being an executor.
There is only limited coverage of more complicated topics, such as trusts. Since trusts have to be set up by professionals anyway, you will presumably have professional advice.

Conclusion


A book like this is not gripping read for the beach in the summer time. But if you are following a do-it-yourself (DIY) financial plan, you will need to read the relevant sections of a book like this at the beginning of your plan. It is a handy reference, but it will slowly go out-of-date as tax laws change. But the basic principles of the tax system change slowly, so you do not need to worry about updating to the latest editions every year. Once you have your bearings, you just need to keep track of what is changing.


(c) Brian Romanchuk 2014

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