Tax Tips for People Who Still Work

I’ve received a bunch of emails asking for personal tax tips because not everyone has a blog that’s making $30,000 a month. The biggest problem with giving out personal tax tips is there aren’t that many. If you work for employment income, then you are in the most screwed group in the world. Not only do you pay the most tax and have the least tax breaks, the government takes their money from you at source! When your employer gives you your paycheck, he has to withhold the estimated tax owning because Uncle Sam doesn’t trust you to pay the tax if you were given the full amount. If you’re still trading hours for dollars, keep these tax tips in mind.

Don’t Ever Get a Tax Refund

Getting a tax refund means YOU OVERPAID YOUR TAXES. It is the stupidest thing you can do. If you get a tax refund, it means you loan YOUR MONEY to the government for a whole year INTEREST FREE. The amazing thing is, most people are happy to get a tax refund. That just blows my mind! When someone tells me they’re getting XXXX amount back as a tax refund, my reply is, “I’m sorry to hear that.”

If You Do Get a Refund, Put It To Work

When you buy a RRSP (401K or IRA in the US), you trigger a tax refund because your employer withhold tax based on you not buying one. If you were in the 40% tax bracket, a $10,000 RRSP contribution will give you a $4,000 tax refund. Instead of spending this refund on toys, what you should be doing is putting the refund back into the RRSP.

Let’s assume you are in the 40% tax bracket and have $10,000 to invest into your RRSP. What you do is go to your bank and get a RRSP loan for $6,666.67, add in your $10,000 and buy $16,666.67 of RRSP investments. This will trigger a tax refund of $6,666.67 ($16,666.67 X 40%) which you will use to pay back the bank. Your cost will be 1 to 2 months of interest at most (interest on RRSP loans are not tax deductible). The bank can give you this loan below Prime because it’s extremely safe and they know they’ll be paid back with the tax refund.

With the above strategy, you no longer have a tax refund (well, you do but it’s going to the bank) but you’ve increased the funds you put into your RRSP by a huge amount. This will make an big different at retirement time. $10,000 a year at 8% for 20 years will turn into $494,229.21. However, $16,666.67 at 8% for 20 years will turn into $823,715.52. The formula on how much you can borrow so the tax refund matches the RRSP loan is:

Amount available to invest divided by 1 minus your marginal tax rate.
In the above example, it’s $10,000/(1-0.4)=$16,666.67

The above only works if you have not maximized your RRSP contribution limit ($18,000 or 18% of 2006 income, whichever is less). The majority of Canadian (and I suspect Americans as well) do not maximize their registered retirement savings accounts because they do not have the spare funds.

Buy Your 2008 RRSP Now

Most people are buying RRSP for 2007 because that is the tax year everyone is filing for. However, the smart people bought their 2007 RRSP last year and are now buying RRSP for 2008. When your employer deducts taxes from your paycheck, he does so based on the assumption that you will not be buying any RRSP investments. If your employer were to make source deductions based on you buying a RRSP, they would not withhold as much tax money. By buying your 2008 RRSP now, you can make your employer withhold less taxes.

Say you buy $10,000 of 2008 RRSP at the start of year and you’re in the 40% tax bracket. This will trigger a $4,000 tax refund when you file your 2008 tax return in 2009. However, you can take the RRSP receipt to the Canada Revenue Agency (Canada’s version of the IRS) and get a letter from them that tells your employer to make source deductions based on your gross income less the amount of your RRSP contribution. This will give you about $334 extra per month ($4,000 divide by 12). When the 2009 tax season comes, you will have no refund and you will get an extra year of tax-free RRSP growth because you brought the RRSP at the beginning of the 2008 instead 2009.

If you just brought your 2007 RRSP and don’t have any money to buy your 2008 RRSP, then borrow the money from your bank to buy it. Take the RRSP receipt to get the CRA letter and use the extra money you get from each paycheck to help pay back the loan.

Make The System Work For You, Not Against You

Too many people let the tax system beat them up. They complain about paying too much taxes but are jumping for joy when the tax man returns money that they overpaid. The key to making the tax system work for you is by becoming financially literate. A financially literate person would know that if he gets a tax refund, he messed up.