The Importance of Understanding Your Income Tax Return

Spring is finally here, birds are singing, the snow is melting and the deadline to file our income tax return is almost upon us! I have a feeling that not many take pleasure in preparing their income tax return, even for myself, despite being a person who likes playing with numbers, I find that preparing my tax returns can be somewhat tiring.

tax return grid calculatorHowever it is highly important to have a good understanding of your tax reports in order to properly plan your finances and reach financial independence as quickly as possible. In addition, it is necessary to have a good grasp on the impact of your financial decisions on your taxes in order to plan how you will invest your money and what your strategy will be to withdraw or generate the amount that will be used to cover your expenses once you reach financial independence.

Even if you have an accounting firm complete your income tax return, take the time to revise them and more importantly, to understand them. I’ve seen so many mistakes made by various firms, most often because they weren’t well informed on the employment situation of the person and did not ask for specific receipts or documents allowing the person to obtain additional deductions. At other times, it was the person in question that omitted to hand in certain necessary documents or that did not mention various aspects of their lives that could give them a fiscal advantage, simply because they were not aware that it could apply to them.

Here are the reasons why I consider that it is essential to understand your income tax return:

Your tax return guides you in your investment choices:

By having a good comprehension of your income tax return, it is more obvious to see the benefits of contributing to certain types of investments. For example, you can directly witness the impact that a contribution to your RRSPs has in lowering your taxable income.  

If you look a little further in order to better understand the impact of this reduction on your tax rate, for example, you can refer to step 2 of Schedule 1 of your Federal Income Tax report to better visualize the salary brackets of the different tax rates and consider whether an additional contribution to your RRSPs may have the effect of reducing your taxable income under a different tax bracket.

Additionally, you will see that there exists certain deductions for various types of dividends or for certain types of investments. This could guide you in your choice of investments if you are already in a position to maximize your RRSPs and TFSAs.

Furthermore, a good understanding of your tax reports also allows you to better grasp the financial impact of the deductions available from your employer and to take advantage of them. For example, you might have the options to purchase back years of pension in the registered pension plan of your employer which would have the effect of increasing your registered pension plan deduction and thus reduce your taxable income.  

Your tax return allows you to become aware of certain credits and deductions and their requirements:

One more reason to understand your taxes is that by going through all the slips and guides available to help you file your tax returns, you have the opportunity to discover the existing tax credit programs.

For example, the Income Tax Return Guide for 2016 presents the main new changes for 2016 in which is described the RénoVert tax credit which is a refundable credit that is equal to 20% of the portion of your eligible expenses that exceeds $2500 for eco-friendly renovation work on your residence. By reading up on this tax credit, you could decide to reorganize your priorities in terms of renovation work to be done to your home and decide to proceed, in the next year, to work that was already planned in the near future all the while saving a part of the costs thanks to this credit.

Furthermore, you will be aware of all the different requirements in order to qualify for certain credits and thus be better prepared when you will be in the position to claim them. For example, the guide details the entitlement conditions for the tax credit for children’s activities. In this section we can see that, among other things, you must keep your receipts and that various types of activities can allow you to claim this credit such as a program of extracurricular activities offered by a school.

Your Tax return could enable you to reach your financial independence sooner

In summary, the advantages of having a good understanding of your income tax returns mentioned above, could allow you to reach your financial independence sooner.

An excellent example of this can be found in this article by Mad Fientist : Retire Even Earlier Without Earning More or Spending Less. In short, Mad Fientist uses his ‘’laboratory rat’’ which is an example of a 30 year old man on the road to financial independence, under various assumptions such as a 50% saving rates before taxes, in order to demonstrate the impact of various optimizations on his trajectory towards financial independence.chart buddies

In the article, Mad Fientist applied various strategies allowing to reduce the amount of money paid on taxes by the laboratory rat which, in the end, reduces the number of years the lab rat will need to work by 2 years. That is quite impressive especially considering that his working career before the changes was only projected to be of about 10 years.

The optimizations applied were to, among other things, maximize his 401(k) which is equivalent to take advantage of an employer registered savings plan and the employer contribution to it, and to maximize his Traditional IRA which is equivalent, approximately, to our RRSPs. Hence this highlights the importance of taking advantage of the registered savings accounts that give fiscal advantages such as tax deferral.

Having a good understanding of the impact of your fiscal advantages and of the deductions available thanks to a good understanding of your income tax returns can therefore allow you to reach your financial independence sooner.

In the future, I would like to examine various fictitious scenarios in order to try to determine the fiscal impact of the investment choices according to various circumstances. For example, the situation will be greatly different for a person who plans on becoming financially independent thanks to rental income versus a person planning to do so with income invested in the stock market versus a person who intends on starting his own business.

Resources to better understand your tax return:

Personally I use TurboTax  to prepare my income tax returns. I believe that it helps me be better organized and that it removes some of the worry of forgetting something. However, as the many questions in the help section of the TurboTax website shows, the software is not foolproof, yet it is possible to get some help online or on the phone with representatives from the company if you do encounter a problem.  

Furthermore, you will find everything that you need to prepare your income tax returns, including the guides of the Canadian Revenue Agency website (General income tax and benefit package for 2016 ) and the Revenue Quebec website (Income tax return, schedules and guide for 2016). You can also research those websites for more information concerning specific lines or credits.

If necessary, contact the agencies directly for help. I’ve had both good and bad experiences when doing this, but in general, the agents are great for giving advice and guiding you through any questions.


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