Posts Tagged ‘taxes’

Over the last few weeks, it seems every article I read is about taxes.  There are articles discussing the merits of the Paul Ryan tax plan; there are articles about President Obama’s Buffet rule tax plan and of course there are the articles about the tax rates of both Mr. Romney and President Obama.

The issue I have with all these discussions about taxes and tax rates is that they never tell you if they are talking about marginal or effective tax rate.  Why does it matter?  It matters because using one versus the other can lead to very different conclusions about what is a reasonable tax rate and how much someone pays at the end of the day. There is a lot of loose talk about marginal tax rates and average tax rates (also called effective tax rates).   The intermingled and often incorrect usage of these two different rates is distorting the numbers bantered about in the tax debate and confusing the whole discussion.

So what is the difference?

  • Your marginal tax rate is the rate of tax you pay on each additional dollar of income you earn.  In most news stories this is the tax rate being discussed  because it requires no calculation.  The top marginal tax rate for federal taxes in 2012 is 35%. So if that is your marginal tax rate and you get a $100 dollar raise, you will pay 35 dollars more in tax than before.
  • Your effective or average tax rate is the rate of tax you actually pay on your whole income.  It is affected by the different brackets of income you have earned and needs to be calculated (see below). The discussion of how much taxes Mr. Romney and President Obama pay is all about their effective tax rate — the rate of tax they actually pay.

Now how can these two different rate distort the tax debate?  Let’s look at an example.

Let’s say you are single and you make $50,000 from a salaried job with no investment income and no deductions; then your marginal federal tax rate is 15%. This means you pay 15% on ‘the next dollar’ after $50,000 and every dollar thereafter.  You will then add your state tax of say 9% and payroll taxes (social security and medicare) of 7.65% (temporarily reduced to 5.56% for 2011 and 2012).  Now, you might think that your effective tax rate is around 32% (15+9+7.65=31.65%). This is wrong but this is exactly the way that the media, clients and writers of comments on news article often talk about taxes. I think this is the basis for a lot of the idea that taxes are too high.

Now, lets look at the actual effective tax rate of our hypothetical tax payer. If we assume for simplicity that you have no deductions, at an income level of $50,000 then your effective federal tax rate is actually 8.96%.  How is that you ask? First, everyone gets the standard deduction and personal exemption which totals to $9,500.  This is an amount you don’t pay taxes on at all.  This means your taxable income is really only $40,500. Next, because the tax code is progressive you actually pay a 10% marginal rate on income under $17,400. You only pay the 15% marginal rate on income above $17,401.  Therefore, once you average all of this out, your effective rate of federal tax is lower than the 15% marginal rate, just 8.96%.

You can use a calculator such as this take-home-pay calculator from calculator.net to find out what your total effective tax rate from earned income will be before deductions including state and payroll taxes. I ran the same state rate as in my marginal tax rate calculations and the effective overall tax rate is 24% (23.6%)  and not 32% derived from using only marginal rate figures.

So without doing anything different in income or rates I have shaved 8% off “your tax.”  This is why it is important to know when people are quoting tax rates which one they are using.  It’s the same reason there are laws to require discussions about interest rates to be done in APR. There are many other ways to discuss interest, but to allow consumers fair comparison among lenders they need to be using the same calculations so you can be sure you are comparing apples to apples.

To allow a fair discussion about tax policy and fairness we all need to be using the same numbers.


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So what should you do with your RRSP if you leave Canada? The simple answer is you can keep your RRSP as is.  However, if you want to access the funds in the future there will be a 25% tax withholding, this amount is considered your tax paid. If you are happy with this you don’t need to do anything further.

If you believe your tax payable should be less than 25%, you can elect to file Canadian taxes and the difference would be refunded.  Keep in mind that for RRSPs the amount you redeem is considered income for that year, which means unless you have a small RRSP and no other sources of income, your income tax payable for the amount is not likely to be less than 25% .  You may also need to report the amount redeemed as part of your income in your new country as per that country’s income declaration requirements.

If you are certain ahead of time that your income tax payable would be less than 25% you can fill out Form NR5, Application by a Non-Resident of Canada for a Reduction in the Amount of Non-Resident Tax Required to be Withheld. This will reduce your withholding before the redemption even occurs.  This process isn’t any easier than filling out taxes, but it only needs to be done every 5 years so it will save you needing to fill out taxes each year if you are doing multiple redemptions.

Another option is to convert your RRSP to a Registered Retirement Income Fund (RRIF) and receive regular payments from the accounts.  The same minimum withdrawal requirements apply for RRIFs as they do with RRSPs and the 25% withholding tax also applies to all payments (unless your country of residence has specific tax treaties).  A reduced tax withholding amount of 15% is possible for US-Canada. This reduction applies if the payment is less than the greater of 10% of fair market value or twice the minimum withdrawal requirement (amount of withdrawal < greater [10% of FMV, 2x RRIF minimum withdrawal]).  A preferential NOTA BENE rate can be acquired but only if redemption is scheduled for regular periods.

As an example, suppose you have a $100,000 RRSP (as of December 31, fair market value) which has now been converted to a RRIF, you are currently 65 years and you want to make withdrawals.

The minimum required for RRIF withdrawal for the year is 4% or $4000.  You would like to withdraw $12,000 a year or $1000/mon.

Under standard non-resident rules you will receive $750/mon with 25% tax withheld.

If you are in the US, to get the reduced rate: 10% of FMV is $10,000  and twice the minimum withdrawal is $8000. The greater of the two is $10,000.  This means the first $10,000 of redemption is tax withheld at 15% and the excess amount is tax withheld at 25%

So for our example, the first 10 months you will received $850/mon and the last two months  you will receive $750/mon.

If you are in the UK such periodic payments should not be subject to any withholding.

If you are thinking of withdrawing from your RRSP I would strongly suggest you research your own country’s tax treaty and discuss it with your institution before proceeding.  They may still want to withhold 25% and let you deal with CRA to claim any amount that was taken in excess.

Of course, you always need to remember that the amount you take in as income may be subject to taxes in your new tax jurisdiction and will need to be reported as per their tax rules.

You may be able to transfer the amount into registered retirement plans, i.e. 401K etc.   The reverse can be done regularly by any large financial institutions in Canada, but I generally find Canadians financial services personnel have more experience dealing with moving money to US than US financial services personnel have in transferring money to Canada.

So in summary – file an NR5 if you really think your tax rates will be less than 25% and see what number they will come up with. Know your tax treaties and use any tax treaty rules in your favour as able, but be prepared to work with your Canadian institution and educate them as required.

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