As someone who grew up in rural China with no running water, refrigeration, or heating, understanding tax optimization was not on my radar.
But after I immigrated to Canada and studied engineering, I discovered something that isn’t taught in schools: Investments are taxed more favourably than salaried income.
Warren Buffett famously pointed out that Debbie, his secretary, worked as hard as he did but had an effective tax rate of nearly 36 per cent, while his was about 17.4 per cent.
This is because his income mostly came from capital gains and dividends, which are taxed at a lower rate than Debbie’s employment income. The same is true in Canada.
This helped me clue in to the fact that the more of your income that comes from investments, the less taxes (percentagewise) you pay.
They planned to downsize in retirement. Then their adult children moved back home
Combining this knowledge with investing is why the richer keep getting richer. So, I set out to leverage these secrets and become rich myself. I became a millionaire in my 30s, enabling me to retire, travel the world and have a kid in my 40s.
If you follow this rule – structure your income, like Warren Buffett, so that over time, more of it comes from investments instead of a salary – you’ll keep more of every dollar you earn.
Here’s an example:
Consider an employee making $100,000 salary, compared with an investor with a portfolio generating $100,000 a year in capital gains and dividends.
After maxing out RRSPs, the worker be paying $20,570 or 20.57 per cent in taxes. But if that income came from a portfolio instead of employer, and 50 per cent of it was from capital gains and the other 50 per cent from eligible dividends, you’d be paying just $3,875 or 3.88 per cent in taxes, assuming you have no other income.
Why?
Only 50 per cent of capital gains are because the government wants to encourage investment to enable economic growth.
And eligible dividends are taxed even more favourably – in most but not all cases. This is because dividends are a company’s after-tax profits that get distributed to its shareholders.
So, for eligible dividends, which publicly traded companies distribute, you get a dividend tax credit to offset part of the tax you’d pay. This is done to avoid taxing profits that have already been taxed.
In a previous article, I’ve shown you how investment gains snowball over time and overtake your savings. What’s even better is that because investment income is more tax-efficient than earned income, not only is your money working harder than you, less of it is going to taxes.
This is a double win, since investments grow exponentially over time, whereas savings is linear. That means the more you save in taxes, the more money you can reinvest, causing your gains to snowball faster.
‘I was laid off. Should I put some of my severance into my RRSP to maximize tax savings?’
Over time, as more of your income comes from your investments rather than your job, the less you pay in taxes and the more you have left over to enjoy your life.
Now you know why investors have more free time than employees. While you can’t make a portfolio from nothing, the money you save from your job, invested over time, will grow faster than your savings and you get to keep more of it.
If you want to become rich, convert your savings into more tax-efficient investments so that one day you can stop being an employee. Because as Warren Buffett said: “If you don’t find a way to make money while you sleep, you will work until you die.”
Kristy Shen and Bryce Leung retired in their 30s and are authors of the bestselling book Quit Like a Millionaire.
