The article “Planning Through Salary Swings” was originally published on MoneySense on October 18, 2017.
How to best plan given uncertain income
Q: My income fluctuates quite widely from year to year. How do I plan for this and how do I handle the tax implications of such income swings?
A: Yours is the challenge of many a commissioned salesperson or business owner, David. The thought of a stable salary and defined benefit pension plan may be appealing to some, but others, like you – and me – prefer a little more control over destiny. That control doesn’t always mean stability, however.
For starters, I think everyone should have a reserve or emergency fund, particularly those whose jobs are riskier or whose income is variable. An emergency fund doesn’t necessarily mean having six months of expenses sitting in a savings account earning pennies in interest. It could mean a healthy TFSA balance that includes an allocation of conservative, liquid investments. It could mean a secured line of credit available with a low interest rate.
Having tens of thousands of dollars sitting idle for your whole life may be comforting, but it could usually be put to better use invested in an RRSP or TFSA or used to pay down debt.
So, the concept of an emergency fund, David, can look different for different people. Regardless, if you have variable income, make sure you have resources for lean times.
From a tax perspective, fluctuating income tends to mean fluctuating taxes. I’ll assume you are self-employed rather than a commissioned employee, as employees should have their tax determined at source by payroll withholdings.
When you’re self-employed, you typically need to make quarterly income tax instalments to the Canada Revenue Agency if your tax owing is more than $3,000 in two consecutive years. If you live in Quebec, the threshold is $1,800 federally and $1,800 provincially and you may need to juggle both federal and provincial instalments.
Once you have had two consecutive balances owing, the CRA or Revenu Quebec will issue quarterly income tax instalment reminders. These reminders look like bills and many people think they must pay them, but in fact, they’re just suggested payments.
The idea is to pre-pay your tax owing for the current year so that you can’t eternally have large balances owing every April. Instalment payment dates are March 15, June 15, September 15 and December 15. Instalment reminders for the March and June payments are sent in February and for September and December in August.
You can base your instalment payments on one of the following three options:
1. No calculation option: Pay what is suggested on your instalment reminders. The calculation is a bit confusing. It’s based on one-quarter of your tax owing from 2 years ago for each of the first two payments. For the second two payments, it’s your tax owing from last year, less the first two payments requested, divided by 2.
2. Prior-year option: Pay one-quarter of your tax owing from last year for each of the four payments. This is best if your current year’s income and tax payable will be similar to last year but much less than 2 years ago.
3. Current-year option: Pay one-quarter of your estimated tax owing for the current year for each of the four payments. This is best if your current year’s income and tax payable will be much less than both last year and 2 years ago.
If you don’t pay enough or pay on the appropriate instalment dates, David, you will be charged instalment interest. The rate is currently 5%. So, if you have cash in the bank or an available secured line of credit, you’ll probably come out ahead using those sources to make instalment payments rather than getting dinged with instalment interest when you file your tax return.
If your income is rising every year, you’d probably be best to just pay what CRA requests. But a low-income year may mean you don’t have to pay any instalments or not as much as you’ve paid in the past. If cash flow is tight, the last thing you want to do is pay an instalment payment at a time when your income is down, just to get the money refunded the next April. This amounts to lending money to the CRA until you file your tax refund – at 0% interest.
If you’re registered for GST/HST/QST sales tax, which applies to most businesses earning over $30,000, you will also have to juggle quarterly sales tax instalments as well. Bookkeepers are a must for business owners so you can focus on your business rather than your bookkeeping.
If you’re incorporated, tax planning can be a little easier because you can more effectively smooth your income from year to year. The dynamics go beyond the scope of today’s article and likely don’t apply to you, David.
From a budgeting and long-term retirement planning perspective, variable income can be a challenge. I think you should try to treat your personal finances a bit like your business income and expenses. You can make reasonable estimates about future income – both gross income and net of expenses – to set spending and savings targets.
I think it’s reasonable to look at your income for, say, the past three years and try to estimate low, mid and high targets for the coming year. I’d make spending and savings decisions based on the low target so as not to pre-spend your optimistic make-believe income that never comes to fruition. I’ve encountered business owners who do this year in and year out, always expecting things to turn around tomorrow. It’s a sure-fire way to live beyond your means, rack up debt and get behind on your tax payments. Employees make this mistake as well, but business owners with fluctuating income and the potential for downturns are particularly at risk.
If your optimistic expectations turn into reality, this will allow you to move your low, medium and high estimates upwards, continuing to spend and save based on the low target. The good years may be the years that you do your variable spending like a more lavish vacation, David. But if lavish vacations become a fixed expense, just make sure it’s an expense that fits into your low-income estimate.
From a savings perspective, remember you don’t have to deduct RRSP contributions in the year you make them. So, if you’re making regular RRSP contributions and you have a low-income year when you’re in a lower tax bracket, you still claim the contribution in the year you make it, but you can defer the deduction to any future year. Doing so may result in a significantly larger tax refund by simply waiting a year to claim the deduction.
TFSAs may be that much more versatile a tool for business owners who can access funds in a down year and make larger RRSP contributions using their TFSA savings in a higher income year.
Good luck, David. In the short-term, don’t overpay your taxes. Aim to always pay the minimum instalment to avoid interest, but not loan your money interest-free to the government. And in the long-term, plan for the worst and hope for the best.
Jason Heath is a fee-only, advice-only Certified Financial Planner (CFP) at Objective Financial Partners Inc. in Toronto, Ontario. He does not sell any financial products whatsoever.