How To Avoid Getting Put Into A Higher Tax Bracket And Other Useful Tax Strategies
We’ve met many people whose income level fluctuates from year to year. They may find themselves paying more than they expect at tax time. This is because when you have a higher income, your income may be bumped into another tax bracket, causing you to pay higher tax rates at upper-income levels.
Ways to stay out of the higher tax brackets include increasing your retirement contributions, delaying appreciated asset sales, batching itemized deductions, selling losing investments, and making tax-efficient investment choices. In short, this is a losing battle unless you have financial expertise and indepth knowledge.
To give you a leg up and offer tips that should help you save your hard-earned money and succeed in this cut-throat world, the tax and accounting experts at ACT Services want to arm you with the most accurate information on this topic. To do this, we’ve listed a few ways to help you avoid being put in a higher tax bracket.
1. How do I avoid getting put into a higher tax bracket?
Most accountants advise their clients to pay themselves a salary and bonuses (and possibly dividends if more income is required) to ensure the corporation doesn’t earn over $500,000. By keeping below the $500,000 income threshold, the corporation can take advantage of the small business deduction, bringing the combined federal and provincial tax rate to 12.5%.
This sounds better than the 26.5% total federal and Ontario tax for any income that exceeds $500,000. But compare this to your income tax rate. The marginal tax bracket could be up to more than 50%. You don’t have to be an accountant or a financial planner to see that a combined corporate tax rate of 26.5% is better than the above 50% personal level marginal tax rate.
The fact is, most accountants are still focused on maximizing distributions of company profits to shareholders in the form of a salary, bonus, or dividends. But of course, this will expose you to a higher personal tax rate. As a result, you will have less after-tax money for investing than if you left the money in the corporation.
2. Why let your corporation do the investing?
Not surprisingly, the average accountant is still focused on maximizing distributions of company profits to shareholders in the form of a salary, bonus, or dividends. But of course, this will expose you to a higher personal tax rate. As a result, you will have less after-tax money for investing than if you left the money in the corporation.
Instead, figure out your annual spending needs and only take out that amount from the corporation. Leave those after-tax profits within the corporation and invest them with the objective of seeking capital gains for their lower tax rate and their ability to defer payment until you dispose of the investment.
3. Why should I set up separate investment or real estate holding companies?
Suppose you plan on leaving the majority of your cash and investments within your corporation for many years. In that case, it’s a good idea to set up a separate investment or a real estate holding company. A holding company is incorporated to hold income-generating investment assets not needed in the company’s business.
So, instead of using after-tax salary or dividends at a personal level to buy investment properties or other assets, you can borrow money in the form of an intercompany loan ( between operating and holding corp). While the loan is subject to interest, you can charge Canada Revenue Agency’s prescribed interest rate. Although the operating company must record the prescribed interest as income, the holding company can deduct the interest charge as an expense, making the cost of the loan tax-neutral to shareholders.
4. Why let your corporation buy your RRSPs, not your after-tax money?
If you pay a salary and have RRSP contribution room, consider letting the corporation make your contributions. Similar to a group RRSP or a defined contribution pension plan provided by larger companies for employees, the corporation makes contributions to an RRSP on your behalf (within individual contribution limits) with its pre-tax dollars rather than your after-tax dollars.
These contributions are a tax-deductible expense to the business corporation: at a minimum, your company can save at least 12.5% of the combined federal and Ontario small business income tax rate, to a maximum of 26.5%, t. If you were to maximize your contributions, this would amount to a savings of several thousand per shareholder per year.
While these contributions are considered taxable earnings for you (and reflected on your T4 or T4A slip as taxable income), you can neutralize their effect when you deduct the business paid contributions at income tax time (on your T1 form), precisely similar to using your after-tax money to buy RRSP
An added benefit? If the contributions are made each month, you can also benefit from dollar-cost averaging, the principle that investing regularly can reduce the average cost per unit over the long term.
5. Why paying yourself with dividends is smart?
Paying yourself with dividends is still a guaranteed strategy that will pay you less in taxes.
Let me explain. Everyone knows that if the corporation pays you a salary, you will be able to contribute to an RRSP. And most professionals and business owners believe they should increase their salary to increase their RRSP contribution room. But this usually means moving into a higher tax bracket.
You would need to pay an average of 21% to 50% in personal income taxes (based on marginal tax rates) to make room for the maximum RRSP contribution of 18% of taxable earnings to a maximum limit of $29,210 in 2022.
Even after paying more taxes to create an RRSP room, would you actually make the maximum allowable contribution? The numbers suggest not.
Only a handful of tax filers (7%) were able to contribute to their maximum RRSP rooms. 93% did not! So the question for you is, why pay more taxes just to get an RRSP room? Using the taxes saved to invest in mutual funds, exchange-traded funds, stocks, real estate, or in growing the business instead is cheaper.
6. Why should you avoid paying CPP premiums?
Receiving a salary also means making CPP (Canada Pension Plan) contributions. But as a business owner, you have to pay both portions of CPP as you will be both the employer and the employee. So not having to pay CPP can save you money.
Besides, the number of years paying yourself with dividends, which are not considered “earned income,” could be treated as a general drop-off provision in the CPP benefits calculation. The general drop-off period is the number of years of low earnings in the calculation of your CPP pension. As of January 1st, 2014, the drop-off period for calculating your average earnings increased to 17%, allowing up to eight years of your lowest earnings to be dropped from the calculation. This means that your CPP benefits will not be materially affected when you reach sixty-five by your decision to forego a salary.
Another point to realize is that relying on CPP for retirement income is risky. With so many baby boomers set to retire and birth rates declining, there won’t be enough young people entering the workplace to replace retirees. We can see our future in Japan, where the sale of seniors’ diapers is higher than that of baby diapers. This demographic reality will put a severe strain on CPP payouts. The US Social Security is projected to be insolvent by 2030, another eight years. So, how is your CPP?
7. Why is it a good idea to split your income with your spouse and adult children?
By incorporating your company, whether as a small business or if you’re a medical doctor or dentist, you create opportunities to split income with members of your family. This involves making your spouse and adult children shareholders of the corporation and then paying them dividends.
This is a sound tax-reduction strategy if you have a lower income-earning spouse, a spouse staying home to provide care to young children or aging parents, or a spouse on maternity or paternity leave. In all instances, the spouse will be taxed at lower marginal rates.
Adult children can also use the dividends as a source of income or funding for their education instead of relying on your after-tax money or a student loan. However, effective January 1st, 2018, to qualify for this provision, the spouse or adult children must work a minimum of twenty hours per week at the business.
If you have any more questions about accounting, and tax services, get in touch with ACT Services. With over twenty-five years of experience in accounting, taxation, and advisory, we believe in a personal yet professional approach and provide services to businesses, corporations, and individuals.
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