Reducing Taxable Income and Debt Management
This article features a debt management theme, let’s use a real-life example to help you understand how to take these concepts and apply them to your situation.
Take you or your family’s gross, (yes I know you think it’s gross,) before tax income. Annual salaries under $35,000 will be taxed at 26% (figures for Canada). If you earn between $35,000-$70,000 tax owing will be 32%. Salaries above $70,000 but below $113,804 will be taxed at 36%, above $113,804 will be taxed at 39%. This includes provincial (state) tax.
Step 1 – Subtract tax owing from your monthly salary.
Step 2 – Subtract debt payments from the remainder. Debt includes mortgage payments and any contractual fixed or variable payment such as lease payments or minimum payments on a credit card or line of credit.
Surprised at how little is left? Let’s take a look at 2 more examples:
1) is single person earning $42,000 annually which equates to $3500 monthly. Less tax of $1120 leaves $2380. Subtract debt payments of $1000 the remainder is $1380.
2) is a two income family earning $75,000 yearly. This works out to $6250 per month. Taxes will take away $2250, leaving $4000. If debt payments are $1500 they will have $2500 for saving and living expenses. It’s no wonder that savings levels are far below the recommended 10%, and people feel squeezed.
Before we get depressed let’s stop and ask ourselves are there ways to be more efficient with the money we earn? Can we lessen the impact of probably the two biggest demands on our paycheques? The answer is YES.
First of all we can pay less tax by using deductions to reduce our taxable income. It is even possible to get a tax refund if someone has enough deductions. The most well known of the tax deductions is the RRSP contribution. A taxpayer accomplishes two things with his or her contribution. First there is immediate tax relief and second they are securing their quality of life in the future. Other deductions include child care expenses, rental or capital losses, and union dues.
A second way to reduce taxes is to take advantage of all available tax credits. Credits reduce tax owing. Two common credits are medical expenses and donations but many people do not use these to their maximum benefit.
So what about debt? Are wage earners resigned to it as a fact of life? The Financial Planners Standards Council recommends 20% of after tax income EXCLUDING mortgage payments as a safe level of debt. How does your percentage compare?
When lending institutions want to determine whether someone will be a good borrower they use a ratio of total debt to income. Who do they say would be a good borrower? Someone who can support debt payments of 35-42% of their income. Compare that to the FPSC recommendation. The borrower may be in debt well into their retirement or longer but as long as he or she can make the monthly payments the lending institution is satisfied.
If all those percentages are confusing, this is what we recommend based on our financial planning experience. A debt to gross income ratio of 20% or less is a safe level of debt. 21 to 35% is a grey area, where the wage earner will have more difficulty achieving their long term financial goals. These are the people banks love because they make the most money off them with the least risk. A debt income ratio above 35% is high. That person needs advice and a plan to get out of the vicious debt cycle.
The third area of the household finances is discretionary income. Those fancy words describe what is leftover after you meet all you monthly commitments. This is the place where people see their money drip slowly away like a leaking tap. Want some examples? BANK FEES!: $2 on this ABM withdrawal, $1.50 for x number of cheques written. Take a look at your bank statement for a couple months, ditto for credit card fees and unnecessary insurances, fines or late payment penalties included, cell phone and long distance plans–>the list could go on, does yours?.
Some solutions to help you on the path of strong debt management? I know most people hate the ‘B’ word so I won’t mention it (BUDGET). However, the number one step towards getting a handle on your spending so you can plan for a future that has a good quality of life is to know where your money is going.
Want some motivation to know how you are spending your wages? Take your annual salary and multiply it by the number of years you will be working. For example if you earn $42,000 and you are going to work for 35 years (age 20-55), you will have earned $1,470,000. That calculation is conservative, as people may work past 55 and will probably get raises during that time period. How much of that more than a million dollars will you still have?
So your stubborn and you or your family do not want to do a ‘B’, here is an activity in lieu of the hated task:
Buy some very small post it notes. Or if you are resourceful cut up some bigger ones.
EVERY time you take out your wallet or debit card or write a cheque, write how you spent the money on a post it note.
At the end of the month make two columns with the post it notes. Label one column NEED the other WANT. Then see which column is longer. (You’ll also see how you change wants into NEEDS in a hurry!) You could also save every receipt or bill and do the same thing. But the act of writing and recording your spending will have more of an impact.
In closing here is an example of two separate people we’ve dealt with. One is a person in his late 50s who had spent all his RRSPs and was still in debt. He was depending on 5 pensions for his retirement. The other was in his late thirties with a massive line of credit that he was only making the minimum payments on. It’s not how much you earn but how you manage and keep of what you earn. That is what taking control of your finances means.