Welcome back all. Sorry for the hiatus
Okay, you are now a partially established wood pro, making a living, if not a fortune, out of your shop. “Quo vadis?” (where to from here?)
Well, first things first. Pay off all the bills you accumulated getting started. The credit card purchase of that tool. The hundred bucks aunt Milly loaned you to get the table saw blades. And so on…
Okay, the bills are paid (lucky you) and you’re up to date on the household stuff, is there anything you should be doing now?
Once you start making a buck, the tax man wants his taste! More than his fair share if he can get it. So, is there anything we can do to keep his grimy fingers out of our pockets? (without ending up in a government institution that has locks on the doors and bars on the windows that is)
YEP! There is!
First, make sure every possible deduction is taken care of, and is well documented. Get receipts for everything! I don’t care if it’s one lousy postage stamp, every penny counts. It all adds up. Comes tax time, you want every penny you can legitimately claim listed and accounted for. Why pay a cent more than you legally have to? The government has enough $1,000 screwdrivers already! Don’t buy them another one by not keeping track of your business expenses.
What kind of expense gets missed? You’d be surprised. If you go for coffee with someone and you talk business, it is deductible. Take someone to dinner and talk business? Same thing. I’m sure most of you know this, but there are other, less obvious items that fit this catagory. Since these differ from place to place and this us an international site, I won’t go further into this here, but direct you to your accountants to direct you on this one. Ask them. Make them earn their money! They work for you. Every jurisdiction has its own tax code and its own “loopholes” that only accountants know for sure. Learn which ones fit your business. They can add up to thousands of dollars a year. It’s your money. Do you want it in your pocket, or in the tax collector’s? I know which one I would choose.
Now we do a little tax planning. I am often asked what the difference is between a financial planner and an accountant. My usual reply is, an accountant tells you what your mistakes will cost you. A planner tells you how to avoid the mistakes. The accountant is, by training, a historian of sorts. He is most interested in what has already happened. The planner thinks about the future. His training is in making the most of what you have. How to get to where you want to be in the most efficient manner possible. Both accountants and planners have their places in the broad scheme of things. There are even some planners who started out as accountants and took the several years additional training to become planners. Not too many, but some.
Okay, what is “tax planning”?
It’s using the tax code to your advantage to pay the absolute least tax legally possible. How? A great example is a retirement account. Here in Canada we have the RRSP, or Registered Retirement Savings Plan. Within certain limits, money put into these plans can be deducted from your taxable income. In other words, if you made $50,000 in taxable income last year, but put $5,000 of it into an RRSP, you only have to pay taxes on the remaining $45,000. Not bad, eh?
But what happens to that five grand? Does it disappear into the ether, never to be seen again? That would be silly, wouldn’t it? Instead, it gains interest just like any other bank account (this is a simplified explanation, there are quite a few options as to where the money can be deposited and how it earns interest or other types of income for you). The big benefit to you in addition to it being untaxed is that the income generated inside the account is also tax free while it remains in the plan!
Let’s take two hypothetical taxpayers, mr. A and mr B. Both make $100,000 a year (lucky devils), both are 29 years old and both are single. (nothing against married folks, I’m married myself. Just want to keep this simple)
Now mister A puts $10,000 of pretax income in an RRSP while his friend mr. B puts the same amount in the same bank and the same kind of account (a 5 year guaranteed interest account for this example), but, his is non-registered.
Now let’s set some ground rules for the sake of this hypothetical. The interest rate will be 12% and both individuals are in the 50% marginal tax bracket. (I know, 12% is out of sight these days, but it was quite normal, and even low when I started in the industry, and it will be again some day, plus, it makes things easier for this illustration).
Now accountants have a rule of thumb called “the rule of 72”. What this means is, if you divide the interest rate into 72, the result will be the number of years it takes for your money to double.
So, using the rule of 72, mister A takes his $10,000 and puts it in his RRSP. Since it is a tax deferred plan, he pays no tax on the money, so the whole amount goes into the0 account.
Mr. B on the other hand has to pay taxes on the money before he gets it into his account, so at a 50% marginal tax rate he only gets to put $5,000 in his savings account. The tax man gets the other $5,000.
So right off the bat mr A has twice as much in his account as mr B.
Now we go 12 years into the future. Both friends are now 41 years old. Both still have their accounts untouched. Neither has put any more into their accounts. (silly boys!) Both are still confirmed bachelors.
Where do they stand?
Mr A has his initial $10,000 plus the interest, which according to the rule of 72 has doubled his money twice, so he now has $40,000 ($10,000×2 x 2). He is still paying no tax on the earnings in the account, so his total is $40,000.
Mr B had his initial amount taxed, so he only had $5,000 to start with. The same rule says his money has also doubled twice, right? However, he has to pay taxes on his income on the account, so his account only doubled once. He now has $10,000 ($5,000×2 x 2 divided by 2 for taxes)
12 more years down the road. Both our friends are now 53 years old. Neither has made any changes to their accounts. They’re both still single.
Mr A’s account has doubled twice more to a comfortable $160,000, while mr B’s has only netted a doubling once after tax to $20,000. (are we seeing a trend here?)
12 more years and both our buddies are 65 and ready to retire. How do they stand now?
Mr A’s fund has once again doubled twice for a total of $640,000. Not too bad, eh? Mr B’s has doubled only once after the taxman got done with him, so he is left with a total of $40,000.
Now to be fair, Mr B’s money has had the taxes paid on it already, so it is all his, free and clear. Mr A’s has been sheltered, but if he takes it all out in a single lump sum (the worst possible option tax wise), he has to pay that 50% tax on it. All of it. Even then, he is still left with a net of $320,000.
Who’s better off?
Ah, the joys of sheltered compound interest! :)
If anyone doubts these admittedly hypothetical totals, check them with your accountant or banker. After doing some heavy calculator or computer work, they’ll be remarkably close to the ratios I have shown here.
Now to show another fact these figures show, the importance of starting retirement planning EARLY!
For this we need only to look at mr A. If he had waited 12 years to start his account at age 41, he would only have HALF as much to retire on. ($320,000 total instead of $640,000 pretax)
If he had waited until age 53, it would only be a pretax total of $160,000, a quarter of what he would have had if he’d been smart and started back at age 29.
If your head isn’t spinning by now, you either weren’t paying attention or you got all A’s in math. (grin)
Remember, these examples are for a single, one time deposit of $10,000 of before tax income. See how much difference good planning can make?
That’s enough for tonight. (heck, I used to get $49.95 a head for that little lecture, filled out a bit more with nice color graphics on the projector screen and a nice brochure that recapped the same info so you didn’t have to take notes, but the same basic content) I think I’m going to try to get some sleep.
Good night all.
-- The nicer the nice, the higher the price!