I filed my taxes on Wednesday. Perhaps, influenced by blogging, this was the first year I truly looked at my tax return closely above and beyond looking at the refund or payment line on the last page of the return. Reading the last page of the tax return is akin to buying a book and reading the last page and ignoring the rest- you know how it ends but you miss all the details.  And, as they say, the devil is in the details.

If you flip to your tax return, there should be a page devoted to “Total Income” which, as the name implies, is the aggregate of all the income you have made in any tax year. Income for tax purposes is typically divided into the following sections (I am going to skip the government benefits like Old Age pension and child care benefits):

• employment income
• taxable dividends
• interest and other investment income
• interest from income trusts (known as “other income”)
• business income
• professional income
• commission income

The lines that should really concern all of us are the passive income items: taxable dividends, interest and other investment income and interest from income trusts (collectively, “Passive Income”). You want these to grow faster than employment/business/professional/commission income (collectively, “Working Income”) for two reasons.

Passive Income is generally taxed more favorable than Working Income. For example, the effective tax rate for dividends in Canada is as low as 3% to 30% depending on you income tax bracket and jurisdiction. The dividend tax rate in the United States is 15% (until 2011). This is generally lower than the top tax rates for Working Income (which can be upwards of 46% of income). In other words, the government, through its tax policy, is encouraging you to invest in passive income instruments.

The other reason is simple- you are putting a smaller amount of effort to yield Passive Income than Working Income to gain a greater reward (and greater take-home due to lower tax rates). The typical reaction to making more money is to increase Working Income by asking for a raise, working more hours (if that’s possible), selling more in the your business etc. This requires a lot of effort and, given that our tax systems is progressive in nature (income tax rates rise as your income does), you are, in many respects, being discouraged by the government to work harder since the harder you work, the more tax is being taken off.  Whereas, Passive Income, such as dividends payments, require less effort to generate and is taxed more favorably.

I am going to use my “taxable amount of dividend” line in my tax return to track my progress towards achieving multiple streams of passive income.  Instead of completing your taxes, filing them and then putting them in a drawer for the rest of the year, consider using it as a tracking tool if you are interested in making passive income.

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I am privileged to be a part of the Carnival of Personal Finance-Chasing Dreams edition hosted by the Happy Rock. Please visit the Happy Rock blog and all the carnival entries.

Have a great weekend.

This post is part two of my contribute to retirement or pay down your mortgage debate. Part I can be found here. Rather than argue for one side or the other, I have run some real life scenarios to see what I would do:
SCENARIO THREE- equity in home is modest and so is retirement portfolio (there is contribution room but it is not massive): This is the hardest scenario to judge. As a general rule, I would apply the tax analysis and contribute to retirement first. However, I am going look at this tax rule in a slightly different light- if your annual rate of return in your retirement portfolio is less than the interest rate on your mortgage then contribute to your mortgage. If you have a low rate of return in your investment portfolio (especially in a low interest rate environment), you need to stop doing what you are doing and figure out what you are doing wrong (either you are chasing the latest fad, paying too much in fees or have poor asset allocation). In the meantime, putting more money into your retirement portfolio before you fix the problem is throwing good money after bad. Until you fix your portfolio, you may as well guarantee a return of investment equal to the interest rate charge on your mortgage by paying down the mortgage.Verdict: contribute to retirement unless your rate of return in your retirement portfolio is below the interest rate charged on your mortgage; in this situation, you need help with your portfolio. Get some and pay down your mortgage in the meantime.

SCENARIO FOUR- significant equity, large retirement portfolio: Why you are reading this blog is beyond me! You clearly have mastered debt managment and investing. Congratulations- please share your success formula with me. Verdict: you tell me, you’re clearly doing well!

Some other things to consider:

• The higher your income, the more likely you should contribute to your retirement because you need to defer taxes. Unless you are highly leveraged, in this case, you may want to pay down the mortgage to reduce your debt exposure.
• If you are self-employed, your choices are a little more complicated; if you are in a business which require a lot of leverage (such as manufacturing), you may want to pay down your mortgage in order to build up equity so you can borrow against it (if you are self-employed, you understand that the bank asks for your first born as collateral no matter how successful your business). In a good year, you may want to contribute to your retirement to defer more taxes. Given that I am self-employed, my choice really depends on what type of year I am having and what cash flow is like at any particular period of time.
• It never hurts to do both at the same time.
• If in doubt, pay down the mortgage- its simple, elegant and it works. Here’s something which startled me- I raised my mortgage contribution $64/month in April and my amortization was reduced immediately by 8 months!
• In times of increasing interest rates, it may be more beneficically to pay down a variable rate mortgage. Increases in mortgage rates not only makes the cost of borrowing higher but tends to dampen the return on investment of certain types of equities (for example, banks and consumer discretionary stocks tend to drop as interest rates rise). Given that my variable mortgage just went up 0.1% and it may go up again, I am more inclinced to start paying down my mortgage.

I am sure a Ph.D thesis could be written on this topic (I suspect it already has been) but these are some consideration I would consider before making my decision between paying down my mortgage or contribution to retirement.

Its taken me almost 50 posts but I thought I would finally wade into the contribution to retirement (through an RSP, 401K or IRA) or pay down your mortgage. There seems to be an equal proportion of advocates supporting paying down the mortgage as those who support contributing to retirement.

My thoughts on an emotional level are similar to Four Pillars on this matter- do what you feel is most comfortable. However, the real reason why I am writing this post is that the debate has been framed as an “either or” proportion by some- either you contribute to your retirement or pay down your mortgage. There is no other option. Of course, life is simply not like that. Decisions must be made in the context that we live in. Thus, I decided to actually run through some scenarios and see how I would react.

As a starting point, the following tax analysis on this matter is technical true- you should contribute to retirement instead of paying down your mortgage unless the interest on your mortgage is 3 % higher than your return in your retirement portfolio and you will move your regular mortgage contribution to your retirement account once the mortgage is paid off. As a tax lawyer friend of mine said, retirement contributions results in deferred tax whereas paying down your mortgage does not reward you from a tax perspective (in Canada anyway; in the U.S., you get tax relief by deducting interest paid on your mortgage). It rewards you from debt management and cash flow perspectives so it depends on how you frame the argument- again, context is everything.

However, real life tends to overtake tax analysis so here are some typical life scenarios and what I would do. For shorthand, I will use the term “lack of equity” to describe someone with little equity in their home and “significant equity” to describe someone with a lot of equity in their home. My analysis is underlined with certain assumptions so obviously the results change if the assumption do. Please note that this is not the “right” answer- these are merely the decisions I would make.

SCENARIO ONE-lack of equity, small retirement portfolio: Typically, someone in this situation is either quite young or has over-extended their small net worth to buy a home regardless of age (they may have with-drawn under their retirement funds to make a down-payment on their home). In this case, my inclination is to pay down the mortgage- if you are young, debt is a huge obstacle to financial freedom; if you are older and your mortgage is still quite large, it may be within your best interest to build equity into the home (on the assumption you will downsize on retirement and pocket the profit from the sale of your home to live on). I willingly concede that if you are older, contributing to retirement may be an equally strong impluse but paying down debt also frees up more cash for your heirs after death. It really comes down to your life-style, income and excess retirement contribution room so neither paying down the mortgage or contributing to retirement is wrong for me in this situation. Ideally, I would make a small monthly contribution to my retirement and use surplus cash to pay down the mortgage. Verdict: pay down mortgage if younger if older either option works as long as you are committed to it.

SCENARIO TWO-significant equity, small retirement portfolio: Typically, someone in this situation has either used most of their free cash to make a down payment on their home or used most of their free cash to pay down the mortgage. If true, this means that this person most likely has significant contribution room in their retirement and they haven’t deferred too much tax over the years (because they have not contributed to a registered retirement plan, they cannot rely on the tax deduction that results from a contribution). In this case, I would set up a monthly contribution to my retirement portfolio and use all free cash to contribute to retirement; debt appears under control so its time to build up equity for retirement and defer my taxes more aggressively. Verdict: contribute to retirement.

More to come tomorrow.

In the first post on this topic, I outlined some considerations in structuring real estate investing. This post continues these considerations in the context of stock/dividends and other income:

Stocks/Dividends and other investment income:

• Outside of a corporation, consider having all the stocks issued jointly with your spouse to avoid probate and other estate taxes.
• Remember that passive income made inside a corporation in Canada is taxed at a higher tax rate than if the stocks were held individually.
• It may be a good idea to have an investment “holding corporation” if you are self-employed to creditor-proof yourself or if you are in the highest tax bracket; for high earners, you are being taxed heavily already so the tax disadvantage is not that great and the corporation may allow you some credit-proofing.
• Please note that the lifetime capital gains exemption on the sale of an investment holding corporation does not apply if 50% or more of the income that is being derived is passive income (the rules are complicated- please see an accountant about this). The lifetime capital gains exemption only applies to corporation generating active income.
• HOWEVER, an investment holding corporation may be structured in such a way that the shares in the corporation are simply passed on from family member to family member so that wealth is transferred generationally with minimal tax consequences (again, see an accountant about this).
• An investment holding corporation is more suited towards high income individuals, self-employed or a family with a lot of investment income.

Do NOT mix a real estate and investments in one corporation for liability reasons. Real estate holders are subject to a wide variety of liabilities which holders of investments are not (slip and fall, building code violations, tenant issues). You do not want the money you make in non-real estate investments to be subject to these liabilities.

The above is not for everybody and some of the structuring is quite complicated but, for anyone who has accumulated significant assets, these are some issues to consider. As always, this is purely informational and not tax and/or legal advice. Please talk to your accountant before doing anything. Good luck.

Re Money and the Money Diva have recently commented and posted respectively on the tax aspects of investments. Specifically, there have been comments or posts about tax issues with investing in dividend stocks, the tax characterization of certain income trusts and possibly the tax aspects of real estate investments. Since taxes on investment income is not taken at source, like a paycheck, it is quite important to understand the tax consequences of every investment and, just as importantly, to put aside certain money to pay taxes on it. I am not an accountant but I have done some structuring work in connection with saving taxes and the following are some of the tax efficient structures I have come across (as usual, please do not take this accounting advice; please see your own accountant for qualified assistance).

As a starting point, I would read the Million Dollar Journey’s posts on this subject. It is an extremely good summary on taxes (please note it only applies to Canadians though). The one thing to understand about the Canadian tax system is that it punishes the generation of passive income relative to active income in a corporation. Active income is income you make from your job or business. Passive income is made from investing, rental income and royalties. Outside of the corporation, the tax treatment is neutral in the respect that, removing the dividend tax credit and capital gains from the equation, you are generally taxed at your personal income tax rate.

In a corporation though, passive income is taxed at the highest marginal tax rate (in plain English, the highest tax rate possible). If you mingle passive and active income in a corporation, your active income may become subject to passive income tax rates. This is one reason why a manufacturers owns its building in one corporation and the actual manufacturing business in another corporation. So keeping that in mind, here are some structuring options (assume owners are resident Canadians):

Real estate properties/rental income:

• If you are being taxed at a high personal tax rate, you may want to have a corporation own the investment property; rental income outside of a corporation is taxed as income (i.e. 100 cents on the dollar is subject to taxation at your personal income tax rate).
• To use the tax jargon, you can keep the taxes “flat” on investment properties (inside or outside of a corporation) by racketing up the mortgage payments so that the cash flow coming in is almost equal to the mortgage payment (in order words, your taxable income is quite low because you are using all of your profit to pay off the mortgage). The short amortization rate on your mortgage will increase the equity in the investment property quickly allowing you leverage to buy other properties (this is the most tax efficient way to build a mini real estate empire relatively quickly but it does have its risks).
• The above point assumes you are buying the real estate investment properties for capital appreciation and not cash flow though. If you are buying it for cash flow, open up a high interest bank account and put your projected tax bill pro-rated on a monthly basis into that account- at the very least, your taxes are covered at the end of the year and you haven’t spent it (plus you make some interest).
• If you want to keep real estate in the corporation and derive tax efficient cash flow, consider incorporating a corporation which provides landlord/property management services to your real estate holdings. This corporation is making active income and the income derived is being taxed at a lower tax rate. You can take the money out of the landlord/property management corporation on a tax-friendly basis by dividending out money to yourself. You should only consider this if you have a lot of property or are profitable out of a few properties and you are being taxed at a high personal income tax rate and/or the rental income would push you into another tax bracket.
• The primary advantage of holding investment property in a corporation is that you can sell the shares of the corporation rather than the house/building itself or structure the corporation in such a way to transfer the shares inter-generationally on a tax efficient basis. In Canada, you cannot generally use the capital gains exemption on the sale of this type of corporation for reasons listed below. In the United States, I understand this method for selling the shares rather than the house is done regularly by sophisticated investors of real estate.

In my next post, I’ll post about structuring and stocks/dividends and other income.