Budgeting and Cash Flow

Budgeting and Cash Flow

Capital Gains

Capital gains are money created by selling something for a higher value than its cost. There are ways to engineer these gains to create income, but this is not predictable so it should not be a regular input into your budget. There are exceptions for years when you want to have extra capital or are rearranging your financial situation, but this gets more into bigger picture financial planning as opposed to the annual budget.

Withdrawals and Pensions

If you have registered accounts and they generate predictable income or you are forced to make withdrawals each year like a RRIF or LIF, this income will form part of your budget. For RRSP and TFSA accounts, withdrawals are optional. When you turn age 71, the RRSP becomes a RRIF and you would have a minimum amount that you would have to extract each year according to a government table of withdrawals. Though the money has to be withdrawn from the RRIF, it does not necessarily have to be spent – you can choose whether this money is available for spending, or if you will reinvest it in another account (e.g., your TFSA or non-registered account). The key takeaway is that this money will appear in your budget and you would have to decide what it should be used for.

If you have a fixed pension from an employer or an annuity from an insurance contract, the payments will be predictable and are indicated to you in advance. Many of these situations will index your payments to inflation, meaning that they will increase your payments as inflation rises. The assumption is that inflation rises every year which theoretically does not have to happen. There may also be limits to whether the payments will cover the entire inflation rate increase or a portion of it. These details can be obtained by whoever is paying you the pension and annuity. The same treatment can be applied to CPP, OAS or other government pensions like disability pensions.

Mixed Investments

Many people have investments in mutual funds, exchange traded funds (ETFs) or similar products that have multiple types of income within one product. The way to predict income from such products is to split them by how much income comes from interest, dividends, capital gains (which I would ignore for purposes of an annual budget), and possible return of capital. Return of capital is when an investment gives you your invested amount back to you over time for purposes of differing taxes. I bring this up because it will be cash flow available for your budget and it will be fairly predictable. The tax consequences are dealt with when the investment is sold. If you have someone managing money for you, they can provide you with the information of income from different sources. The composition or asset mix within each product or a portfolio of products may change each year, so this is something to keep an eye on.

The key for the investor is that income can vary by factors beyond their control – which are primarily market forces. There are choices that can be made in terms of asset allocation and risk in your investment portfolio, but income can change unexpectedly. Unlike the entrepreneur, changes in income will come more slowly and will not be as drastic. The expenses side would be treated like the employment income situation. If the investments contain expenses that can be changed, this would be something to track in your budget. For the retiree or fixed income situation, the income is stable and does not require much effort. The focus will be on expenses and whether they are covered.

Taxation on Investment Income

Different forms of investment income will have different tax rules applied to them. Interest income is taxed at the same rates as employment income would be, though there will likely be no tax withheld so you will need to be prepared to pay tax at a later time. Dividend income has a more complex tax treatment, involving a gross-up and dividend tax credit, but will be taxed at a lower rate than an equivalent amount of interest income. Only half of your capital gains are included as income for taxation (or equivalently, they are taxed at half the effective rate of other income). Additionally, investment income may be in tax shelters that negate these rules. Gains in a TFSA or RRSP are tax free, though any withdrawals from an RRSP will count as income and be taxed accordingly.

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