Large successful corporations do everything in their power to lower their taxes. They set up their businesses in locations that have low tax rates, they minimize their taxable income, they maximize their tax-deductions and tax-credits, and they control the timing of their income and deductions so that taxes are kept to a minimum. In short, they make sure they legally reduce their tax bills as much as possible. Because of these tax strategies, successful corporations make more and more money every year. You need to do the same.
How much tax do you pay?
In Canada, according to the Fraser Institute, tax freedom day for the average family in 2015 occurred on June 10, 2015. This means that if the average family in Canada had devoted every dollar they started earning as of Jan 1, 2015 towards paying their annual tax burden for the year, they would have only finished paying all of their taxes by June 10, 2015. According to this calculation, the average family in Canada is paying approximately 42% of their income each year in taxes.
In the United States, according to the Tax Foundation, Tax Freedom Day for 2015 occurred on April 24, 2015. And even though this is better than Canada, it still means that the average family in the United States is paying close to one-third of its income in taxes.
Just like corporations, you need to do as much as you can to minimize your taxes through legal methods. Do not lie to the taxman and do not commit tax evasion.
How do I lower my taxes?
To legally minimize your taxes you need to consider all of the following:
- The best place to live and work from a tax perspective.
- How to minimize taxable income.
- How to maximize tax credits and tax deductions.
- How best to control the timing of income and deductions.
I discuss points one and two below and all of these points in detail in my book Think Like a CEO and Get Rich.
The best place to live and work
One of the biggest factors large corporations take into consideration when deciding where to set up their business, is their tax burden. For example, it isn’t just coincidence that Google and many other large corporations have their European headquarters located in Ireland and that Ireland has one of the lowest corporate tax rates in all of Europe.
If you have the ability to move or to work in many different places, then considering the tax rates of these different places wouldn’t be a bad idea. It’s amazing how different some tax rates can be, even in different cities of the same country.
Obviously, tax rates are not the only thing worth considering when debating a move. Quality of life, cost of living, and employment opportunities, just to name a few, would also all play into the decision. Nonetheless, let’s assume you are able to choose where you can live and work, and look at how this decision could affect your finances from a tax point of view.
Let’s assume you have the choice of living in the fictional locations of either City A or City B. Let’s also assume that you could get a job earning you roughly $60,000 a year in either of these two cities. With this in mind, let’s compare the income tax burden of living in either of these two fictional cities and determine how this tax burden might affect your financial freedom fund.
Let’s assume the income tax burden on $60,000 of employment income is $14,841 in City A and $19,004 in City B. How much savings do you think you could amass if you and your partner chose to live in City A, instead of City B, and invested your combined savings of $8,326 in a tax-free savings account (Roth IRA) each year?
If you and your significant other were to live in City A, versus City B, and do nothing else but invest the income tax savings you realized into a tax-free savings account each year, then, after 25 years, you and your significant other would have accumulated a combined total of close to $1.8 million (assumes a CAGR of 7%). This simple analysis is a powerful incentive to act like a large, successful corporation and, if possible, move to a location that offers a lower tax burden.
Furthermore, the above analysis once again demonstrates how cutting costs, whether it is through moving to a location with lower taxes or by living more frugally, and making periodic investments into your financial freedom fund can, over time, result in great wealth.
How to minimize taxable income
Besides moving to a location that offers lower taxes, successful corporations also do a good job of minimizing their taxable income. This doesn’t mean that successful corporations minimize their total income; it means they minimize their taxable income.
Minimizing taxable income is all about finding ways to avoid paying taxes on some of your total income. How are corporations able to do this? They do this by taking advantage of government incentives that allow certain investments to be made tax free or allow certain investments to defer tax. You need to do the same.
For many individuals, the most powerful way to minimize taxable income is by investing in tax-advantaged retirement savings accounts. In Canada, these tax-advantaged retirement savings accounts are usually registered retirement saving plans (RRSPs) and tax-free savings accounts (TFSAs). In the United States, the most common tax-advantaged retirement savings accounts are 401(k)s, Roth 401(k)s, individual retirement accounts (IRAs) and Roth IRAs.
It almost always makes sense to maximize your investments in these types of tax-advantaged retirement plans before investing outside of these plans. Moreover, if you are lucky enough to work for an employer that will match your contributions to one of these retirement plans, then you absolutely need to take advantage of this. Not doing so is saying no to free money!
How tax saving from 401(k)s and RRSPs add up
Over time, the savings realizes from tax-advantaged retirement savings accounts really add up. If you started saving $10,000 each year in a 401(k) or RRSP (Canada) starting at age 25, then you would end up with roughly $2.1 million by the time you reached 65 years-old (assumes a CAGR of 7%). Even if you slowly withdrew this money in later years in a 30% tax bracket, you would still end up with roughly $1.5 million.
In contrast, if you left that $10,000 outside of the 401(k) or RRSP (Canada), you would lose $3,000 of it to the tax man each year and only have $7,000 to invest. If this $7,000 were then invested and paid 30% taxes each year on all its returns, you would only end up with a total of $870,000 by the time you reached 65 years old (assumes a 30% tax bracket and a CAGR of 7%). This means you would get roughly $630,000 more money if you used the RRSP or 401(k)….and this doesn’t even factor in any type of matching your employer might offer.
The tax advantages of dividend paying stocks
In the U.S., at the time of writing this, dividends typically qualify for a lower than ordinary tax rate if they are received from U.S. corporations and meet the holding period requirements. In Canada, eligible dividends received from Canadian corporations also get preferential tax treatment. Dividends received from foreign corporations, more often than not, do not receive any type of preferential tax treatment.
In both Canada and the U.S., the tax savings offered by dividend income, as opposed to ordinary employment income, can be substantial.
At the time of writing this, it would be possible for an individual investor to earn up to $40,000 a year in eligible dividends, and a couple to earn up to $80,000 a year in eligible dividends, and pay virtually no tax at all in many Canadian provinces, assuming this was that investor’s only source of income.
In the U.S., it would possible for an individual investor to earn up to $37,450 in qualified dividends, and a couple to earn up to $74,900 in qualified dividends, and also pay virtually no federal tax at all on this dividend income, assuming again that this was the only source of income.
Dividend tax savings are usually only available for investments made outside of any tax-advantaged savings account. Moreover, the income distributed by REITs is typically not eligible for any type of dividend tax savings.
Taking advantage of all our tax-advantaged savings accounts and the tax advantages associated with dividend paying stocks is a major reason my wife and I were able to achieve financial freedom in our mid-thirties. We currently earn tens of thousands of dollars every year from tax free savings accounts or dividend paying stocks and pay virtually no tax on any of it. I discuss all the tax free strategies we use in my book.