Handling Taxes in Financial Planning

Taxes in Financial Planning

Handling of taxes in personal financial planning is often ignored or simplified because the topic seems too complex. Yet without considering the true impact of taxes on your financial plans your plans may not be realistic. It is important to have a clear understanding of how your financial plan handles taxes, whether it be estimating, averaging, or calculating actual amounts based on known formulas and rates. What complicates the calculation is that the amount of tax depends on how much you make, what type of income or investment return you received, eligible deductions, and many complicating conditions the government applies. Yet despite all this it is possible to adequately include the handling of taxes in your financial plan to the extent needed to ensure a reasonably accurate and realistic plan, and without too much complexity. Of course greater accuracy implies greater complexity. MyFinancePlans has carefully considered this in designing their financial planning spreadsheet templates.

Taxes on Income

First lets look at taxes on income before looking at taxes on investment returns, because they are handled differently. Incremental income is taxed at your marginal tax bracket rate. Basically each higher tax bracket has a higher marginal rate. That means that if you have a certain level of total income that puts you into a certain marginal tax bracket, then each additional dollar you make is taxes at the marginal rate of that bracket. This ensures that those with higher income pay more tax.

But lets not confuse marginal tax rate with average tax rate. The marginal tax rate is the tax rate on the next dollar you make. It matters because it is an indicator of how much additional tax you have to pay if you make an additional amount of income. The average tax rate is simply the total tax paid divided by the total income. Your average tax rate is lower than your marginal tax rate. If you include deductions and credits in the calculation, then you average tax rate (after deductions and credits) is your income (after deductions and credits) divided by you total income. Your average tax rate (after deductions and credits) is typically lower than your average tax rate (before deductions and credits). For lower income people their average tax rate (after deductions and credits) may be zero.

Taxes on Investments

Different types of investments provide different types of returns which are taxed differently. Interest earned is considered income and is taxed as regular income. Each additional dollar of interest earned is taxed at your marginal tax rate. Bond interest is also considered income and is taxed as regular income at your marginal tax rate. Stocks can provide two types of return, capital gains realized when you sell the stock for more that you paid for it, and dividends paid to you on regular intervals (monthly, quarterly or annually) for owning (holding) the stocks. Capital gains (depending on the country you live in) may be taxed at 50% of regular income. Dividends are little more complicated but are often a very good deal depending on the country you live in and the country of the stock. Dividends may be taxed at an effective rate below zero percent (for low income persons) to higher that of capital gains but less than that of regular income (for high income persons). ETFs or mutual funds can provide capital gains and dividends.

However any investment held within a registered plan will be taxed according the rules of the plan, which means they can be taxed in a completely different way than if they were not in a registered plan. For example for Canadians, all returns from RRSPs are taxed as income and taxed at the regular rate at the time of withdrawal, all returns from TFSAs are not taxed at all (ever), and returns from RESPs are taxed at the regular rate at the time of withdrawal.

Handling Taxes in Financial Planning

There are several ways to include the impact of taxes in your financial plan.

The first approach, which is used by the Basic edition of MyFinancePlans, is to use only after tax amounts in both the annual plan and lifelong plan.

The second approach, which is used in the Lite edition of MyFinancePlans, is to use before tax income as well as actual taxes in the annual plan, and use only after tax amounts in the lifelong plan. This gives you greater accuracy on your annual plan for the current year.

The third approach, which is used in the Full edition of MyFinancePlans, is to use before tax income as well as actual taxes and deductions in the annual plan, and use before tax income and average taxes and deductions in the lifelong plan. This allows you to better estimate and adjust the impact of taxes over the years.

The fourth approach is to include actual tax calculations for different types of income (employment, business, interest, dividends, capital gains, etc.) in the annual and lifelong plan. I use this approach in my own personal plans, and you could too if you grow your expertise in your financial plan spreadsheets and your personal tax situation.

We recommend the following sites for increasing your understanding of taxes and they impact your personal financial planning.

For Canadians: TaxTips.ca

For Americans: USTaxTips.net