Six Steps to Financial Freedom, Step Five
I’m not a tax expert. But I do know a few things about taxes and how to mitigate them as you build wealth. That’s why step five, in the six steps to financial freedom is Take Control of Taxation.
In this world nothing can be said to be certain, except death and taxes. – [Benjamin Franklin]
I don’t know if it was Ben Franklin who said it first or not, but that is the most widely accepted first form of the statement I could find. What’s not certain is when you will eventually die or how much tax you will be expected to pay. I’ve already touched on some of what we need to do about early death in step two – Regulate Risk. Now let’s take a closer look at taxes.
First the bad news, everybody pays. Nothing I’m going to show you here is going to change that fact. But it might not have to be paid all at once, or even by you.
I already talked about this back in step three – Rule Retirement. In Canada we have the RRSP program. One of the great things about RRSPs is that any money you put in now reduces your tax bill until you take it back out. If you make $100,000 per year you have an average tax rate of 35%. That means you pay $35,000 in taxes and have to live on $65,000. If instead you put the maximum (18%) of your income into an RRSP you could report an income of $82,000, your average tax rate would then drop to about 20% and you would get to live on $65,600. ($82,000 x .2 = $16,400, $100,000 – $18,000 – $16,400 = $65,600). Granted that’s not much of a difference until you consider that you would then turn around and invest that $18,000 at say 6%. Do it every year for about 30 years and you have $1.6 million!
If you stop working and start taking it out when you are 65 you must take out a minimum of about 4% or $70,000 per year. Now I already said it’s taxed when you take it out but as you might have guessed, your tax rate on $70,000 is even less, about 18%, so now you are living on after tax income, in retirement when your expenses should be a lot less, of $57,400.
My math isn’t exact here and I doubt very many of my readers are going to be able to put the full 18% maximum into RRSPs, but you get the picture. By putting money away now, in your higher earning years you reduce your tax bill and differ your payments until such a time as you are in a lower tax bracket. It might not feel like it but you will pay considerably less tax in the long run and if you follow my instructions in steps one through four you will have the money to do this.
But here’s where it gets really interesting. What if I told you there was a way that your estate could pay almost no tax upon your death?
There is nothing that eats away the value of your estate faster than probate taxes and capital gains. If you follow the above plan and retire with $1.6 million, kept investing at 6% and then died at age 90, there would still be about $1 million left over in your account. If that money went into your estate it would automatically be subject to tax at about 45%, plus probate tax at an additional 1.5%. As a result your estate would only be worth $535,000. Ouch!
Did you know life insurance proceeds are tax free and never subject to probate? Did you also know that participating life insurance continues to grow cash value right up until the moment you die, even after the contract is fully paid up?
I already pointed out that you will always pay the tax, there is nothing we can do about that but let’s compare the cost of a participating life insurance policy to a $465,000 tax bill.
In the above scenario we know that you will need $465,000 to pay the taxes on your estate if you die at age 90. So if you’re 40 now, and you project out the growth of a participating life insurance policy for 50 years, how much life insurance to you need? Answer – $125,000. And how much does that cost? For a male non-smoker about $4,500 a year on a 20 year contract or $90,000. When you turn 60 you stop paying and watch the value of the policy continue to grow for the rest of you life.
So, pay the government $465,000 of your hard earned money when you die, or pay a life insurance company $90,000 over the course of 20 years while you are living. Seems like a no-brainer to me. Put in terms of percentages, pay the government 46.5% of your estate or pay the insurance company 9% and keep then rest!
Now I’m not saying this will be everyone’s situation but if you follow my advice from the earlier steps it’s not that far-fetched of an idea. And because we are working in percentages the math works pretty much the same no matter what the actually dollar figures are.
Bottom line – save as much as you can in an RRSP to reduce your tax bill now and in retirement and buy a participating life insurance policy to pay the capital gains and probate taxes on your estate. Overall you could reduce the amount of tax you pay out of your pocket significantly.
For information on this and other Meekonomist approved methods for Taking Control of Taxation write to firstname.lastname@example.org