I have a few New Year's resolutions. Too many, I think. In fact, I've already fallen off the bandwagon on one: I haven't visited the gym this year yet. So, I've downgraded my own expectations. I'm now counting it a success if I merely drive by the gym three times each week.
There is one resolution, however, that I've been good at keeping every year. It's simply this: I will choose one new tax-saving idea and implement it in 2013. Do the same and you'll be amazed at how much the tax savings will add up over time.
Today, I want to talk about a framework that I have believed in for many years when it comes to tax planning. If you understand this framework, you'll be able to identify ideas that can save you tax. I'm talking about what I call the five pillars of tax planning.
Every idea that exists that can save you tax will fall under one of five pillars of tax planning: Deducting, deferring, dividing, disguising and dodging to save tax. The most effective tax plan will utilize ideas from all of these pillars.
This is the idea of claiming tax deductions or credits to reduce your overall tax burden. A deduction is different than a tax credit in that it is claimed against your total income when you are calculating your taxable income. That is, a deduction reduces your income which is subject to tax. A tax credit, on the other hand, is claimed after you've calculated your taxable income and have applied your tax rate to that income. Once you've calculated the tax otherwise owing, a tax credit will reduce that tax amount.
Deferring is the concept of pushing a tax bill that would otherwise be payable today, to a future year. You may still owe the tax, but paying it in the future is better than paying it today. The reason? You'll have those dollars in your hands, working for you, in the meantime. If, for example, you owe $1,000 in taxes today but can push that tax bill into the future by, say, 10 years, the true cost of that tax bill drops to just $614 (in today's dollars) if we assume you can earn 5 per cent on the taxes deferred. If you can defer the tax for 15 years, in this example, your tax bill drops to less than half, to just $481.
Dividing to save tax is often referred to as "income splitting." This is the idea of moving taxable income from the hands of one family member who may pay tax at a higher rate to another who will pay tax at a lower rate. The idea, of course, is to keep the income in the family but pay less to the taxman. There are special rules – the "attribution rules" – which are designed to prevent you from simply reporting your income on someone else's tax return, but there are ways to still accomplish this dividing of income.
Disguising to save tax is the concept of converting one type of income that may be taxed highly into another type of income that is subject to lower rates of tax. Under this pillar, we are not eliminating taxable income, but simply choosing a type of taxable income that is taxed more favourably.
Now, I admit that "dodging" to save tax sounds akin to tax evasion, which is illegal. The concept of dodging, however, is quite acceptable – so hear me out.
Dodging is the idea of structuring your affairs so that income which might otherwise be taxable is no longer required to be reported on your tax return. If you don't have to report amounts on your tax return, you won't face tax.
Over the next few weeks I will share the top specific strategies that fall under each of these pillars.
The most important thing to keep in mind is that you don't have to implement more than one or two of the strategies in 2013 to make a meaningful difference in the amount of tax you pay.
And tax strategies can be cumulative in their effect. That is, if you commit to implementing one or two ideas each year, the impact on your net worth over the course of a few short years can be significant.
So it's not too late to add one more New Year's resolution to your list: Save more tax in 2013.