Tax season

The other week, I received mail from Revenue Canada. I was hoping that it would be my last Government Sales Tax (GST) credit for the year but it wasn’t. It was just my NETFILE access code. NETFILE is a system which allows people to file their income tax via the internet. It’s a lot quicker than having to mail it and less paperwork as well.

This mail got me thinking about my investments again. I do a lot of playing around with my money. Most of it goes towards my bills, some of it goes into my chequing account, a small portion goes towards personal spending and whatever is left sometimes goes towards charity. I have nothing else better to do with my money than to move it around and play with it. Most of it is set aside for a rainy day while the rest I can’t touch.

The money that I have saved up for a rainy day doesn’t get deposited into my bank account. Instead, I hide it from myself or I just place it somewhere and forget about it. I like it when I hide it in my winter jacket’s pocket because I end up finding it again around Christmas time. Finding $20 in my pocket is quite the excitement even if it’s was originally my money.

To prepare for this year’s tax season, I’ve decided to increase my Registered Retirement Savings Plan (RRSP) investment. Every month I would take $100 from my bank account and deposit it into two RRSP accounts. I have one with Royal Bank (RBC) and another with ING Direct.

My RBC RRSP account was opened when I was in my last year of high school. One of the bank tellers asked if I wanted to start open up an RRSP account. At the time, I was fairly young and the thought of retirement had never crossed my mind. Nonetheless, I didn’t see any harm in opening one.

The initial deposit was $25 which wasn’t that high. She informed me that I could start an automatic savings plan where $25 would be withdrawn from my bank account every month. I was working at Burger King at the time and I was making enough to afford to set aside $25 every month so I agreed to that as well.

My initial investment of $25 and the $25 deposit every month as grown since February 2001. According to my calculations, $25/month for 6 years works out to $1,800 in my RRSP but miraculously, I have almost twice as much in that account. I know that there were times where I deposited left over funds into the RRSP but I don’t think I had that much lying around.

Opening up an RRSP account was the best financial decision that I’ve ever made. Every time I do my income tax, I get a lot back. A lot more than what I had initially calculated anyway. I advised all my friends to start one up but none of them appears to be listening. Instead, they complain about not having enough money. They’ll complain that they government is taking too much taxes off their pay cheque and they never have any left over. I’m giving out good advice regarding money but they’re not taking action. RRSP works best when you start out young and every little contribution to it helps.
Little do they know that by putting their money towards RRSP, they’re not only saving up for the future but they’re also reducing their taxes. It’s a little complicated to explain and I’m not an accountant but I’ll try my best to put it the simplest way I can.

The federal and provincial tax rates for 2006 are as follows:

Federal Provincial
$0 – $36,378 15.25% $0 – $34,758 6.05%
$36,378 – $72,756 22% $34,758 – $69,516 9.15%
$72,756 – $118,285 26% $69,516+ 11.16%
$118,285+ 29%

Depending on your gross income (income before deductions) you’ll fall into a certain tax bracket. For example, if you’re making minimum wage at $7.50/hr and you’re working full times, 40hrs/week, you’d be making an annual income of $15,600. That would put you into the first tax bracket of 15.25%. Your federal and provincial tax would be something like this.

Federal tax = $15,600 x 0.1525
Federal tax = $2,379

Provincial tax = $15,600 x 0.0605
Provincial tax = $943.80

Total tax = $2,379 + $943.80
Total tax = $3,322.80

Net income = $15,600 – $3,322.80
Net income = $12,277.20

I hope you’re following me so far. With no contribution to RRSP, you’ll be paying $3,322.80 in taxes. That’s money that goes into the government’s pocket and you don’t see a single penny of it back. If the company that you work for do not deduct this much in tax from your pay cheque, you’ll end up owing that amount to the government. And you don’t want to be giving the government more money than you already have.
One year, my brother didn’t get an income tax refund but instead, he had to pay the government. The reason for this was because he had two part time jobs. Both jobs didn’t take into account the fact that he was working another part time job elsewhere. It was as if the was getting two income but only getting taxed on one. Since he didn’t make that much at either jobs, they only deducted a small amount for tax. The documentation for tax deduction calculations is somewhere around 90 pages long if you care to look at it.

Let’s say he had an RRSP account opened and contributed to it regularly. The most you can contribute is up to 18% of your annual income or $16,500 (amount for 2006), whichever is less. In this case 18% of his income was less, $2808. This now makes his taxable income only $12,792 ($15,600 – $2,808).

Federal tax = $12,792 x 0.1525
Federal tax = $1,950.78

Provincial tax = $12,792 x 0.0605
Provincial tax = $773.92

Total tax = $1,950.78 + $773.92
Total tax = $2,724.7

This shows that he should have only paid $2,724.70 worth of taxes but instead he paid $3,322.80. So that means he overpaid by $598.10 ($3,322.80 – $2,724.70). When he files his income tax returns, he’ll likely get a refund of close to $600. That’s assuming my calculations are correct. Mind you, I barely passed Mathematics of Finance in college.

I have an RRSP account with ING Direct that I contribute to on a bi-weekly basis. The interest rates on ING Direct RRSP accounts was at 3.5% but they recently increased in on January 1st, 2007 to 4.25%. I didn’t have that much money invested in that account to take full advantage of the higher rate so I thought about getting a loan to max out the total amount that I could contribute. I didn’t want to borrow too much so I just applied for a $2,000 loan.

ING Direct $2000 RRSP Loan

ING Direct was willing to loan me $2,000 at 6% interest so I had to weighed out the options to make sure that taking this loan won’t cause me to lose money. If I borrowed the funds from them, I would have a year to pay it all back but the first payment starts the following month after I’ve been approved for the loan. That would mean that I would have to pay back $172.13 ($2,065.60/12) every month. I could afford that so I went for it.

ING Direct 3.5%

If I deposited $2,000 into my RRSP account and continue to contribute my regular amount, I would have gained $82.18 in interest (at the old rate of 3.5%). The amount of interest that I was going to be charged for the loan was $65.60 so by taking this loan, I’m already making $16.

ING Direct 4.25%

But the rates was recently increased to 4.25%. With the $2,000 deposited into my RRSP, it will gain $100.12 in interest, subtract the amount of interest from the loan and that would leave me with an extra $34. Does that sound like it’s worth it to borrow $2,000 to make $34?

Of course it’s worth it. You have to remember that RRSP contributions are not taxed. So the $2,000 loan gets deducted from my gross income which in turn reduces my net income. According to an online RRSP savings calculator, by contributing as much as I have, I’ve saved $700. Now, does that sounds like it’s worth it? You bet!

The numbers work out best for those who make more because all they have to do is bring themselves into a lower tax rate category and there’s a chance that they’ll get all the money that they were taxed back. There’s a 6.75% gap between the first two tax rates so you can probably capitalize on that if you know how to manage your finances.