Tuesday, 5 April 2011

How Your Province, Income Level and Investment Choices Affect Your Income Tax

Taxes matter to the investor. What is left to spend after paying income tax is what interests us as investors, not the nominal pre-tax return. There are key elements that an investor should be aware of in order to guide plans and shape investing strategy. As we show below the differences can be very large indeed.

The major tax differences arise from:
  • Type of income - employment, pension (including age 65+ RRIF withdrawals), interest (including RRSP withdrawals), capital gains, dividends, TFSA withdrawals
  • Province - each province has its own tax scale for each type of income, in addition to that of the federal government. Some Provinces have high taxes, some are low and some are in the middle (see the Ernst & Young 2011 Personal Tax Calculator to find where each Province falls in the spectrum). We've chosen three to do our comparisons - middle level Ontario, low tax BC and high tax Nova Scotia.
  • Income level - each type of income in each Province has its own tax scale according to income level (yes, it is reminiscent of the child's song "there's a hole in the bottom of the sea")
Tax Comparisons:
The Canadian 2010/2011 Tax Calculator from TaxTips.ca provides a quite sophisticated free tool (it includes exemptions, deductions, tax credits, adjustments for dependents, age and spouse income splitting) that we have used to gain insight into the bottom line effect of various combinations of the above factors. Our comparison tables are organized by income level. We've chosen three - a modest pre-tax income of $40,000, a middle income of $60,000 and a high income of $100,000. Then we try out different breakdowns of types of income sources to see total tax payable results.

Middle Income - $60k Table

High Income - $120k Table

Modest Income - $40k Table

What the numbers tell us:
  • Interest income always attracts the highest tax and by a lot, no matter what the Province or income level.
  • Healthy doses of capital gain and dividend income can significantly reduce an investor's total tax / average tax rate, especially for high income earners.
  • The mixture of income types makes the most tax difference. The mix of interest, capital gains, dividends etc has a huge impact that is far greater than any difference amongst Provinces. For example, a $60k income could have $10,000 to $11,000 less income tax to pay if instead of being all interest income, it is an even combination of interest, capital gains, dividends and TFSA withdrawals (which are tax-free).
  • The highest tax Province of Nova Scotia shows the most sensitivity to type of income. It has the greatest dollar difference between highest and lowest combination no matter what the income level.
  • The lower the income level, the more the type of income matters ie. the greater the relative difference between highest and lowest tax. In our tables, that shows up in the column "Within Province, Highest to Lowest Multiple". For example, in Ontario, someone with $40k income only in interest would have almost 11 times (10.9 is the exact figure) more tax to pay than if they had only dividend income. At $60k income the multiple is only 4.7 times and at $100k, only 2.9 times.
  • The difference between the Provinces matters less for modest income. At $40k the percent difference in between the highest and lowest Province varies from 1.5 to 4.7% while at $60k and and $120k the difference is generally 5+%.
Practical Implications and Considerations:
  • Use the Tax Calculator to examine how your individual situation works out in detail, then compare against alternatives. Keep in mind that registered accounts (like RRSPs, RRIFs, etc) allow tax deferral of any income, so if you do not need the money now to spend, it is likely better to contribute and keep the funds within such accounts (see our previous post RRSP vs TFSA vs RESP vs Non-Registered Taxable Account?). In any given year, when you have a choice of which combination of accounts and sources to use to withdraw funds, such as in retirement, the calculator may save you hundreds or thousands of dollars. Investors may also want to look at the long term planning software package RRIFMetic, which asserts it can optimize such withdrawal strategies over many future years.
  • Lower income investors should try to shape their income towards dividends and capital gains.
  • TFSAs could, down the road when they have grown enough to contain substantial assets, be a valuable source of supplementary tax-free income that keep total taxes down. During retirement, the TFSA has another nice feature in that withdrawals do not reduce eligibility for OAS and GIS.
  • Within taxable accounts, investors should acquire investments that generate dividends and capital gains. (Dividends and capital gains within registered accounts such as RRSPs, LIRAs RRIFs etc do not matter as there is no immediate tax to pay and the money when withdrawn will be either ordinary income or pension income.)
  • Some people might even wish to consider Provincial tax differences in deciding where to live, though that is quite a drastic measure!

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

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