Design Thinking: Taxes
As Canadians, we may have love-hate relationships with taxes. Or, like many of our cousins to the south, just flat-out hate-hate relationships. Regardless of how we might feel about taxes, they’re a part of our lives. We can choose to ignore them, we can choose to simply tolerate them, or… we can choose to own our approach to taxes and apply (you guessed it!) a design thinking mindset.
If you’re a regular reader, you’ll know that Spring Plan’s theme for 2019 is design thinking – a solution-focused, action-oriented, preferred-future creation system. To date, we’ve taken this approach to income and cash flow and retirement life (not finances, that’s later in the year) planning. This month, because it is indeed that time of year, we’re going to apply our Design Thinking Goggles to tax planning.
As you may know, design thinking is a process that applies five very clear steps to any potential problem or issue:
- Empathize: Gain an empathetic understanding of the problem you’re trying to solve – typically, through research. Empathy is crucial to a human-centered design process because it allows you to set aside your own assumptions about the world and gain real insight into alternative perspectives.
- Define: Accumulate the information you created and gathered in step 1. Analyze your observations and synthesize them to define the core problems you have identified so far.
- Ideate: Generate some ideas. The solid background of knowledge gained in the first two phases allows you to start to think “outside the box,” looking for alternative ways to view the problem and identify innovative solutions to the definition you created in step 2.
- Prototype: This is an experimental phase, with the aim of identifying the best possible solution for each of the problems identified in the first three phases. Produce a number of possible solutions to investigate.
- Test: Now that you’ve got a few solutions, it’s time to test them out to see if any of them gain traction and/or actually get you where you’re going. While this is the final phase of the process, the results could bring you all the way back to step 2, with new, or more robust, definitions of the issues you are solving, which allows you to come up with new, robust ideas, prototypes, and tests.
As you can see, five steps are more than enough. You don’t want to get caught up in “analysis paralysis,” so if you’re someone who is in danger of that, give yourself a time frame for each step or a final deadline to get you to step 5. Then hand that deadline to someone else so they can harass you, like I do with Lindsay.
Taxes: Empathy (for the devil?)
While it’s hard to gain any empathy for either taxes or tax collectors, it’s worth understanding their purpose. In Canada, a significant amount of money (roughly 48%) is spent on people, covering programs for seniors and children, funding health care, education, infrastructure, retirement and disability benefits. Our federal government sends some of the tax dollars collected to provincial governments, which in turn use these funds for education, health care, and social benefits. Tax dollars are also spent on employment insurance, GST credits, farmers, Indigenous people, business, and research.
Operating the government itself takes a little less than ⅓ of tax revenue, covering the costs of firefighters, police, border security, public safety programs, the Canada Revenue Agency (boo! hiss!), defence, environmental programs, public works, veterans affairs, food inspections, parks, Crown agencies like the National Gallery of Canada, and many other governmental organizations and projects (like FACTOR, which supports Canadian music, and the WES Ecosystem Fund which supports gender equality, economic empowerment, and women in business).
The balance of our tax dollars tend to go towards servicing debt, which you may own some of if you have federal bonds or treasury bills.
Obviously, taxes are what make our little society go ‘round, but that doesn’t mean that you must pay more tax than absolutely necessary. There are many ways that the government encourages us to take specific actions through tax legislation, and you should feel pretty great about taking advantage of these. Generally, tax advantages are offered around things that:
- Stimulate the economy, so there’s more money for everybody, such as running a business, creating jobs by hiring employees, and borrowing to invest.
- Prepare you financially for retirement, potentially reducing the amount of government funded benefits you may require in the future, such as saving in your pension, RRSP, and TFSA.
- Contribute to society, hopefully making this a better place to live, such as charitable and political donations.
If you’re one of those rare birds who wants to pay as much tax as possible, (yes, such people exist) remember that these tax advantages are in place because our government wants you to leverage them.
You can find an exhaustive (exhausting?) list of deductions and credits that you can claim to reduce the amount of income tax you pay right here, on the Government of Canada website.
You know what taxes are, and if you’re doing a little planning, it may be that you’re looking to reduce the total amount of taxes that you pay. But, as a few of us say in the tiny, insular world of financial services:
Don’t let the tax tail wag the dog
I don’t know why people say that. It’s a really weird visual. I imagine a dog with a bunch of files and paper clips attached to its tail. Dogs don’t want that. However, it’s been in my head for more than two decades and now it’s in yours. You are welcome.
As much as paying less in tax can feel like a real win, what if paying less in tax means that you’re paying more in something else – like professional fees? What if it means that you won’t be able to take advantage of super cool things like the Canada Pension Plan, Old Age Security, or the Guaranteed Income Supplement? What if means that you save 50 cents today but down the road, when you are much older and have less access to money-making opportunities, it costs you an inflation-adjusted 50 dollars? What if it costs your children hundreds of thousands of dollars when you die, and you happen to like your kids?
At this stage in the Tax Planning Design Thinking Process, it’s important to realize that what we are defining is not how little tax you want to pay today, but what you want to achieve, over the long term in your life, and how income taxes, property taxes, sales taxes, and all those other niggly bits lying about, taking bites at your wallet, impact those both today and far into the future.
Was this just a sneaky way of getting to you to think about your whole life, all at once? I don’t really talk about anything else so… probably.
Assuming you nailed it in step two, defining what you really want out of your life and how taxes and government benefits are components of that, now is the time to start coming up with ideas. If you are not remotely interested in taxes or planning, that is okay. I have a job for a reason, and so do accountants. We can work together to come up with ideas on your behalf.
If you are super nerdy about taxes and do things like volunteer for tax clinics in your community, like Sandi does, then you may want to try to come up with ideas on your own. Remember that this time is not to carry the solution all the way to conclusion but simply to sit about, wondering:
- Would taking full advantage of the RRSP deduction and free tax growth in TFSAs be sufficient to help me meet my combined goals of lowering my taxes now and having a really great, tax minimized income in retirement? Are there certain investments that I should hold in one of those accounts, versus holding them in my not-tax-advantaged (also known as non-registered) accounts to take advantage of the different ways that investment income is treated from a tax perspective?
- Are my children, my spouse, my disabled family member sources of tax deductions that might benefit the whole family? If so, would taking that net increase in cash flow and applying it to my goals of retirement, post-secondary education for my children, covering the cost of care for my disabled family member be sufficient? What else should I consider?
- Would incorporating my business open up greater opportunities to achieve what I want out of life, and would it actually provide me with more net income in my pocket? If so, would the accompanying administrative/maintenance work make this a worthwhile endeavour? What don’t I know?
- If I experienced a capital gain in my portfolio of investments, does it make sense to try a little tax-loss harvesting to reduce my taxes payable this year? What should I know about this strategy to ensure I stay onside with CRA?
Now let’s get back to that weird tax tail wagging that poor dog, who would probably much prefer that its tail was free of such odd encumbrances. You don’t need to be encumbered by a weird tax tail either.
Now that you’ve laid out a few different strategies you may want to consider that, on first glance, look like they may hit some marks for you, “prototyping” in this instance means more, intricately detailed questions.
Remember, whenever you are considering any potential tax strategy, you will want to know not only what income tax it might save you now, but also how this impacts your future and what the “maintenance package” looks like. The more complex a strategy, the more maintenance it will likely require – and that means both time and money. If the maintenance is even partially time, you want to start figuring out exactly what kind of time you are looking at, who is going to give it up, and of course, how much money it will cost you in other non-tax expenses, both now and into the future.
On top of that you need to ask these generic questions of any strategy you are implementing in your life:
- Is it getting you where you want to go?
- Is it in line with your vision of what you want to achieve in the future?
- Does it give you freedom to react to changes, in yourself and in your environment?
- What don’t you know that you should know about this thing, and who has those answers?
Now that you have your answers (wasn’t that magic?), it’s time to build a model. With tax planning, you and/or your advisors can build sample models of your cash flow, your income taxes, and the related assets, liabilities, and goals for the future that are impacted by the decisions you make. This is the test.
Each option, or combination of options, can be tested in that model. It’s one of my favourite parts of the financial planning process – and one of the most frustrating. What if I add this dollar over here and take away this one, over here? What if this strategy is implemented at the same time as that strategy? What combination of decisions will help us arrive at the set of answers we need to push you forward?
If you’re testing a single, relatively simple tax planning strategy, such as taking advantage of the option to split pension income, then you can just run a test version of your income taxes, using as close-to-real numbers as you can find. Run one version with the income not being split, and another version with the income being split. Test alternate percentages to split (you don’t have to split it exactly 50/50 if that’s not the best route for your family) until you come to the best case scenario. The results of those tests will show you the best decision to make in the year ahead. Rinse, and repeat again next year.
If you’re considering RRSP contributions, many tax software programs have an RRSP optimization options that will demonstrate how much tax you could save by increasing your contributions. Match that with a projection of your future portfolio value (all accounts) and the net income you might receive from all sources at retirement, and the right answer for you may come to light.
You may find flaws as you are testing, whether it’s flaws in data, flaws in assumptions, or gaps in your knowledge that you need to fill. That’s when we head back to add your new learnings in to step 2, Define.
As tax legislation changes with the arrival of each new federal and provincial budget – and the occasional new bill that comes out in the middle of the tax year – you’ll need to get back in there and make sure that the data, assumptions, and knowledge continues to apply appropriately.
At the same time, you’re going to change. The goals that you have right now, even if they are fundamentally similar, are going to become more refined, more granular, and specific, as you near their realization.
All these changes mean that the Design Thinking process starts to become a ferris wheel that kicks us off and brings us back with each season. While change often brings with it feelings of overwhelm and frustration, especially in those places where we don’t have expertise (like plumbing – this is something I can’t even begin, and don’t want to comprehend, but cannot avoid), what’s important is that we have a process we can follow, and the experts that we need on hand each time that ferris wheel gate clangs shut.