ADMS 2541 Income Taxes (Chapter 3) PDF

ADMS 2541 Income Taxes (Chapter 3) Taxes are the price we pay for a civilized society. ©2020 York University – Oliver Wendell Holmes 2  Learning Objectives 1. Describe income ta...

ADMS 2541 Income Taxes (Chapter 3) Taxes are the price we pay for a civilized society. ©2020 York University – Oliver Wendell Holmes 2  Learning Objectives 1. Describe income taxes, their purpose, basic format, and relationship to financial planning 2. Illustrate how federal income taxes are computed 3. Basic rules and some advice for filing tax returns 4. Select appropriate tax strategies for different financial and personal situations. ©2020 York University 5. Understand the three most used accounts for investing and their tax implications Personal Finance Planning | School of Administrative Studies 3  Part 1: Overview of Tax System ©2020 York University Personal Finance Planning | School of Administrative Studies 4  Taxes and Financial Planning ▪ Taxes on income pays for the government and government programs. ▪ About one-third* of each dollar you earn goes to pay taxes. ▪ Taxes fund things like public goods such as roads, healthcare, police forces, and OAS (among many others) ▪ Income tax is prescribed and defined in the Income Tax Act ▪ Self-Assessment system ▪ Canada Revenue Agency (CRA) ©2020 York University Personal Finance Planning | School of Administrative Studies 5  Taxes and Financial Planning An effective tax strategy is vital for successful financial planning. Understanding tax rules and regulations can help you maximize after-tax cash flows and net worth. To help you cope with the many types of taxes you should: – Knowing current tax laws as they affect you. – Make employment, purchase and investment decisions that leave you with the greatest after-tax cash flows and net worth. ©2020 York University – Maintain complete tax records. Personal Finance Planning | School of Administrative Studies 6  Four Types of Taxes Purchases: Sales Wealth: tax & excise tax Income taxes on (e.g., GST/HST) capital gains & Estate administrative fees Property: Real estate Income/earnings: & personal property Income taxes Tax ©2020 York University Personal Finance Planning | School of Administrative Studies 7  Who must file? ▪ Every resident of Canada with taxable income must file a return every year. ▪ Resident → live in Canada 183 days or more (calendar year) ▪ Students should file even if they do not expect a return to get GST credit and Ontario Trillium Benefit and record their Tuition credits ▪ CRA: Do You Have to File a Return? ©2020 York University Personal Finance Planning | School of Administrative Studies 8  Tax Rates ▪ Progressive income tax: – Tax rate increases as taxable income increases ▪ Marginal Tax Rate: ▪ Rate of tax paid on the next dollar of taxable income ▪ Average Tax Rate: ©2020 York University ▪ Total tax due divided by total taxable income ▪ Your average tax rate is generally lower Personal Finance Planning | School of Administrative Studies 9  Progressive Tax System (2022) Progressive Taxes 33% $221,708 29% $155,625 $100,392 26% $50,197 20.5% ©2020 York University 15% Taxable Income Personal Finance Planning | School of Administrative Studies 10  Progressive Tax System (2022) You pay 15% 15% on every dollar* you make under $50,197, then 20.5% 20.5% on every dollar you make between $50,197 and $100,392, then 26% 26% on every dollar you make between $100,392 and $155,625, then ©2020 York University 29% 29% on every dollar you make between $155,625 and $221,708, then 33% 33% on every dollar you make over $221,708 Personal Finance Planning | School of Administrative Studies 11  End Part 1 12 ©2020 York University  Part 2: 5 Steps of Calculating Income Taxes ©2020 York University Personal Finance Planning | School of Administrative Studies 13  Personal Income Tax T1 – Required personal income tax form – Four pages – Essential features are important to understand Income Deductions ©2020 York University Non-refundable tax credits Ex. Exhibit 3-6 on page 96 of textbook Personal Finance Planning | School of Administrative Studies 14  Income Tax Fundamentals Total Income: Income from all sources Net Income: Total income reduced by certain deductions. Taxable Income: Amount of income (after allowable deductions) on which income tax is computed ©2020 York University Personal Finance Planning | School of Administrative Studies 15  Basic Steps for Calculating Taxes Step 1: Determine Total Income – Employment, net business, investment income, taxable capital gains, other income Step 2: Calculate Net Income – Account for certain deductions to income Step 3: Calculate Taxable Income – Account for additional deductions and losses carried forward from prior years ©2020 York University Step 4: Calculate Federal Taxes Owing Step 5: Adjust for tax credits Personal Finance Planning | School of Administrative Studies 16  LO#2 Step 1: Determine Total Income ▪ Income from all sources ▪ Total Income consists of four main components ▪ Employment income ▪ Net business income ▪ Investment income (dividends, capital gains) ▪ Other income – retirement income, Old Age Security, child support payments, education-related payments ©2020 York University Personal Finance Planning | School of Administrative Studies 17  Step 2: Calculate Net Income -Deductions ▪ Net Income is total income reduced by certain deductions. ▪ Some deductions include: ▪ Expenses to earned income (usually for investments or an unincorporated business) ▪ Contributions to pension plan or RRSP ▪ Union and professional dues ▪ Childcare expenses ▪ Disability support deductions ▪ Moving expenses* ©2020 York University ▪ Interest on student loans ▪ Other deductions – spousal and child support payments, employment expenses Personal Finance Planning | School of Administrative Studies 18  Step 3: Calculate Taxable Income Taxable Income: Amount of income (after allowable deductions) on which income tax is computed – Net income reduced by additional deductions and losses carried forward from prior years ▪ Security options deductions ▪ Capital gains deduction ▪ Net capital losses of prior years ▪ Other deductions ©2020 York University Personal Finance Planning | School of Administrative Studies 19  Step 4: Calculating federal taxes owing ▪ Taxable income is basis for computing amount of your income tax owing ▪ Tax rates and tax credits are used to compute taxes payable In this step we can identify the Marginal Tax Rate and calculate the Average Tax Rate. ©2020 York University Personal Finance Planning | School of Administrative Studies 20  Step 5: Calculating Net Federal Tax ▪ Tax Credit an amount subtracted directly from the amount of taxes owing ▪ Non-refundable tax credits are subtracted from the amount of taxes owed but can never reduce federal tax below zero ▪ Refundable tax credits are refunded to individuals if they qualify even if their tax liability is zero ©2020 York University Personal Finance Planning | School of Administrative Studies 21  Income Tax Credits Examples of tax credits include: ▪ Basic personal amount ▪ Tuition and education expenses/interest on student loans ▪ Age Amount (65 or older) ▪ Medical expenses ▪ Infirm Dependant (over 18 years old) ▪ Charitable donations ▪ Spousal (equivalent-to spouse) amount ▪ Contributions to CPP/EI ©2020 York University ▪ Caregiver Amounts ▪ Disability amount Personal Finance Planning | School of Administrative Studies 22  Non-refundable tax credits Basic personal tax credit amount (adjusted annually) Personal tax credit amount for dependent spouse Add these up and multiply by the specific percentage, which is currently 15% (the lowest federal tax rate) For example, if you spent $500 on tuition and education amounts what would your tax credit be? ©2020 York University – You would get a credit of $75 ($500 x 15%) Personal Finance Planning | School of Administrative Studies 23  Deductions vs. Credits Which is better? – While credits give you a dollar-for-dollar refund on taxes owed, a number of other factors are involved such as your marginal tax rate. $100 Tax Deduction $100 Tax Credit Amount Reduces your taxable income by $100. The Reduces total taxes payable by the credit amount of your tax reduction depends on amount multiplied by 15%. For example, if ©2020 York University your tax bracket. Your federal taxes will be $100 is spent on tuition, then about $15 reduced by $15 if you are in the 15% tax can be claimed as a direct reduction of bracket and by $20.5 if you are in the taxes ($100 × 0.15). If you are in the 22% 20.5% tax bracket. tax bracket, your total credit is still $15. Personal Finance Planning | School of Administrative Studies 24  End Part 2 25 ©2020 York University  Part 3: Calculating Tax Liabilities ©2020 York University Personal Finance Planning | School of Administrative Studies 26  Income Tax Fundamentals Total Income: Income from all sources Net Income: Total income reduced by certain deductions. Taxable Income: Amount of income (after allowable deductions) on which income tax is computed ©2020 York University Personal Finance Planning | School of Administrative Studies 27 28 ©2020 York University 29 ©2020 York University  Calculating Tax Liability Step 1 Total Income Step 2 Net Income Subtract Deductions Step 3 Subtract additional Taxable Income deductions Step 4 Calculate Taxes Owed Apply tax-rate tables to calculate Step 5 Calculate Tax Credits Calculate and subtract tax credits Final ©2020 York University Final Tax Liability Personal Finance Planning | School of Administrative Studies 30  Federal Income Tax Rates 2019 Rates of Federal 2022 Rates of Federal Income Tax Income Tax Tax Rates From to From Up to 15% 0 $47,630 0 $50,197 20.50% $47,630 $95,259 $50,197 $100,392 26% $95,259 $147,667 $100,392 $155,625 ©2020 York University 29% $147,667 $210,371 $155,625 $221,708 33% $210,371 - $221,708 - Personal Finance Planning | School of Administrative Studies 31  Example: $100,000 taxable income in 2019 Mary had $100,000 in taxable income in 2019 – Calculate her federal tax liability – What is her (federal) marginal tax rate? – What is her (federal) average tax rate? ©2020 York University Personal Finance Planning | School of Administrative Studies 32  Example: $100,000 taxable income in 2019 Calculate Federal Tax Based on Tax Bracket Tax rate Taxable income $100,000 Calculation Tax due 15% on the first $47,630.15 x $47,630 = $7,144.50 Subtract $47,630 from 100,000 $52,370 $100,000 – $47,630 = $52,370 20.5% on the next $47,629.205 x $47,629 = $9,763.95 Subtract $47,629 from $52,370 $4,741 $52,370 – $47,629 = $4,741 ©2020 York University 26% on the remaining $4,741.26 x $4,741 = $1,232.66 Add them together to calculate Basic federal tax for 2019 $18,141.11 Personal Finance Planning | School of Administrative Studies 33  Example: $100,000 taxable income in 2019 Marginal tax rate: 26% – Important because it impacts investment decisions Average tax rate not accounting for tax credit: $18,141.11/100,000 = 18.14% ©2020 York University Personal Finance Planning | School of Administrative Studies 34  Example: $100,000 taxable income in 2019 Calculate Net Federal Tax ▪ Basic federal tax: $18,141.11 ▪ Less tax credits: $1,810.35 ▪ In this example let’s just assume the 2019 Basic Personal Amount of $12,069 ▪ $12,069 x 15% = $1,810.35 ▪ Total federal taxes owing: $16,330.76 ©2020 York University ▪ $18,141.11 – $1,810.35 = $16,330.76 ▪ Average tax rate accounting for tax credit: 16.33% Personal Finance Planning | School of Administrative Studies 35  Example: $100,000 taxable income in 2022 Tax rate Taxable income $100,000 Calculation Tax due 15% on the first $50,197.15 x $50,197 = $7,529.55 Subtract $50,197 from $100,000 $49,803 $100,000 – $50,197 = $49,803 20.5% on the remaining $49,803.205 x $49,803 = $10,209.62 Add them together to calculate Basic federal tax $17,739.17 ©2020 York University Personal Finance Planning | School of Administrative Studies 36  Additional notes – Investment Income Interest Income: Taxed like earned income – Assuming a marginal tax rate is 26%, if you have $500 of interest income ▪ Owe: $500 x.26 = $130 Dividends: Taxed at a lower rate than interest income, a tax credit is applied to reduce double taxation Capital gains: Gain in value of your investment. Only 50% of the capital gain is taxed ©2020 York University – Assuming a marginal tax rate is 26%, if you have $500 in capital gains ▪ Owe: $500 x.5 x.26 = $65 Personal Finance Planning | School of Administrative Studies 37  Additional notes – Tax Credits Charitable donations: Non-refundable tax credit – First $200: tax credit at 15% – $200 ~ 75% of net income: tax credit at 29% – Special tax credit at 33% available if you’re in highest tax bracket Eligible medical expense: Non-refundable tax credit – Eligible medical expense minus the lessor of (1) 3% of net income or (2) ©2020 York University $2,352 in 2019 ($2,479 in 2022) – Multiply 15% Personal Finance Planning | School of Administrative Studies 38  End Part 3 39 ©2020 York University  Part 4: Tax Strategies and Resources ©2020 York University Personal Finance Planning | School of Administrative Studies 40  Withholding taxes Withholding taxes – Employers must deduct an estimate of the taxes you owe on your earned income – Reported to you on your T4 – Employers remit withheld taxes to the CRA Self-employed – Must estimate their income tax on earnings and remit it to the CRA every 3 ©2020 York University months Personal Finance Planning | School of Administrative Studies 41  Example: $100,000 taxable income in 2019 Mary had $100,000 in taxable income in 2019 – Basic federal tax: $18,141.11 – Total federal taxes owing after credit: $16,330.76 – Marginal tax rate: 26% – Average tax rate accounting for tax credit: 16.33% – If she had $15,000 of federal income tax withheld at source ©2020 York University ▪ She owes $1,330.76 – If she had $20,000 of federal income tax withheld at source ▪ She will receive a federal tax refund of $3,669.24 Personal Finance Planning | School of Administrative Studies 42  Making Tax Payments ▪Deadlines & Penalties ▪ Must pay by April 30 of each year. ▪ Filing deadline of April 30th or June 15th* ▪ Automatic 5% penalty on balance owing if late ©2020 York University Personal Finance Planning | School of Administrative Studies 43  Part 4: Tax Strategies and Resources Tax Strategies ©2020 York University Personal Finance Planning | School of Administrative Studies 44  Tax-Planning Strategies ▪ Tax Planning is the use of legitimate methods to reduce one’s taxes ▪ Tax Evasion is the use of illegal actions to reduce one’s taxes ©2020 York University Personal Finance Planning | School of Administrative Studies 45  Four common strategies Maximizing the benefits of deductions and tax credits Tax deferral technique Income splitting technique Tax shelters ©2020 York University Personal Finance Planning | School of Administrative Studies 46  Maximizing the benefits of deductions and tax credits ▪ Be aware of current tax laws and regulations ▪ All people qualify for basic personal deduction amount and income tax credit ▪ Use contributions to retirement plans to defer taxes on income ▪ Capital losses incurred can be subtracted from capital gains ▪ Can claim for eligible dependents ▪ Interest paid on student loans ▪ Tuition fees and education amounts ©2020 York University ▪ Medical expenses ▪ Charitable contributions Personal Finance Planning | School of Administrative Studies 47  Tax Deferral ▪ Deferring taxes for a year or several years saves you money ▪ This method allows you to save some of your income and claim it later ▪ Claim it in a year when your marginal tax rate is lower ▪ Two situations: ▪ Expect income to drop, you can arrange to have some of this year’s income transferred for a few years. ©2020 York University ▪ You do not need all your income for a few years Personal Finance Planning | School of Administrative Studies 48  Tax Deferral ▪ Retirement is the most common form of tax deferral ▪ Employer Pension Plan ▪ Registered Retirement Savings Plan (RRSP) ▪ Capital Gains ▪ Other methods, but these are the most common and simplest to understand ©2020 York University Personal Finance Planning | School of Administrative Studies 49  Income Splitting ▪ Useful when members of the same family earn different levels of income ▪ Attribution rules restrict one from splitting their income ▪ Most common mechanisms: ▪ Registered Educational Savings Plan (RESP) ▪ Retirement income splitting for retired, married couples ©2020 York University Personal Finance Planning | School of Administrative Studies 50  Tax Shelters ▪ Allows you to earn income of some sort and never pay taxes on it ▪ Two very different kinds exist ▪ One involves complicated and risky investment schemes – rarely a good idea ▪ The other is less complicated and less risky ▪ Gain on sale of primary residence ▪ Profit on sale of family business (up to a certain limit) ©2020 York University ▪ Half of capital gains ▪ Income in a TFSA is not taxed Personal Finance Planning | School of Administrative Studies 51  Part 4: Tax Strategies and Resources Three most used accounts for investing ©2020 York University Personal Finance Planning | School of Administrative Studies 52  Tax Free Savings Account Specialized savings account Can invest TFSA money in stocks, ETFs, GICs, etc. Never pay taxes on income earned in TFSA Partly covered in Chapter 4 ©2020 York University Personal Finance Planning | School of Administrative Studies 53  Registered Retirement Savings Plan (RRSP) RRSP is designed to help you save for retirement Any money deposited into your RRSP is deducted from your income in the year you make the contribution Pay taxes when you withdraw the money in retirement Will be covered in more detail later in the semester ©2020 York University Personal Finance Planning | School of Administrative Studies 54  Non-registered accounts Accounts with no special tax treatment or trust status Maximize your RRSP and TFSA contributions first Investment income is taxes as described earlier ©2020 York University Personal Finance Planning | School of Administrative Studies 55  End Part 4 56 ©2020 York University  Part 5: Tax Planning for University Students ©2020 York University Personal Finance Planning | School of Administrative Studies 57  Tax-Planning Strategies ▪ Tax issues important to students ▪ How to report income from scholarships, bursaries, fellowships, grants and RESPs ▪ Scholarships, bursaries, fellowships, and grants are not taxable ▪ RESPs have two components ▪ Contributions – Not taxable ▪ Non-contribution (EAP: Educational Assistance Payments, i.e., CESG) – Taxable in the hands of the student ©2020 York University Personal Finance Planning | School of Administrative Studies 58  Tax-Planning Strategies ▪ Tax issues important to students ▪ Get common deductions such as moving expenses, childcare expenses and interest paid on student loans ▪ Tuition tax credit ▪ Get tax-free income-tested benefits ©2020 York University Personal Finance Planning | School of Administrative Studies 59  Tax-free income-tested benefits The Ontario trillium benefit is a refundable tax credit to assist low-income families. – Combines three tax credits into one single payment: the Ontario energy and property tax credit, the Ontario sales tax credit, and the Northern Ontario energy credit. Canada and Ontario Child Benefits GST/HST credit ©2020 York University – Tax-free quarterly payment that helps individuals and families with low or modest incomes offset all or part of the GST or HST that they pay. Personal Finance Planning | School of Administrative Studies 60  Tuition tax credits Tuition tax credit – Students (over 16) enrolled at a higher education institution – Use school tuition fees to reduce taxable income – Carry forward OR – Transfer up to $5,000 worth of credits to their spouse or common law partner, their parents or their grandparents. Can carry forward indefinitely ©2020 York University You will receive a tax certificate from your educational institution with the total eligible fees paid for the tax year. Personal Finance Planning | School of Administrative Studies 61  End Part 5 62 ©2020 York University