The three investment pillars: 1. Income deferral 2. Income splitting 3. Income conversion
Once you have a portfolio of off-farm investments, you should plan to review those investments on a regular basis to ensure you are achieving your investment goals as well as minimizing the income tax they generate.
A good time to do this type of tax planning is prior to year-end, while you can still take some actions to reduce your tax. In doing this planning, keep in mind three key pillars of tax-efficient investing — income deferral, income splitting, and income conversion.
The benefits of income deferral as a tax-planning technique are twofold: first, your marginal tax rates may be lower in the future and, second, deferring tax effectively discounts your final tax bill.
Much of our retirement planning, such as the use of Registered Retirement Savings Plans (RRSPs), is based on this premise. Your investments grow tax free in your RRSP during your higher income working years. Then, when you are retired and start withdrawing income that is taxable from your RRSP, your income from all sources likely will be lower, hopefully putting you in a lower tax bracket.
The benefits of income deferral apply to short-term income deferrals, such as shifting a tax liability from one tax year to the next. This strategy could be as simple as holding off selling those stocks that have accrued sizable capital gains until a later year when you think your income will be lower.
Benefits also arrive from longer-term income deferrals, which you can achieve by buying tax-sheltered investments such as flow-through shares that receive a preferential tax treatment. If you invest in the flow-through shares of Canadian companies that explore for minerals, oil or gas, you receive about a 92 per cent writeoff of the purchase price, with deductions for the remaining eight per cent over the following two or three years. Your share cost is deemed to be nil for tax purposes.
An added benefit arises from the conversion of fully taxable current income to future capital gains (see “Income Conversion” on page 34). For certain types of flow-through investments, the federal and provincial governments also provide additional tax credits.
Due to the major turmoil and downturn in worldwide stock markets of late, most investors have seen major losses in the value of their portfolios. Many of them may own very few securities that have accrued capital gains right now. This is where tax loss selling might be the only bright spot in a dark year of investing. You may be able to salvage something — and possibly even get a refund of taxes paid in previous years — if you actually sold some of your securities at a loss. You can apply those net losses to offset capital gains in any of the prior three, current, or any future tax years.
The basic principle behind income splitting is to reduce the overall family tax bill by shifting invested money and the income it generates away from the highest-income family member to the lower-income family member(s).
The tax savings from income splitting are due to our “progressive” tax system, under which we pay a higher rate of tax as our taxable income increases.
While there are “attribution rules” that severely limit income splitting among family members, there still are some opportunities that might work for you depending on your particular situation.
First, you should ensure the spouse with the highest income pays all of the family expenses that are not deductible for tax purposes. This allows you to save the lower-income spouse’s salary and other earnings for investment purposes, resulting in the family’s total investment income being taxed at the lowest possible rate.
You also could consider making an interest-free loan to your spouse or children for investment purposes. Under the attribution rules, income
earned by your spouse or minor child on their investments will be taxed in your hands; however, that income becomes their property and it can be reinvested without further attribution to you. Also, funds transferred or loaned to minor children to invest in assets that generate capital gains are not subject to attribution.
You could gift or loan funds to adult family members other than your spouse to invest to earn their own income. The income will be taxed in their hands rather than yours.
Perhaps you might be able to shift assets between you and your spouse. The attribution rules do not apply if you transfer assets to your spouse in return for assets of equal value. If your spouse has a non-income-producing property, such as a cottage, you could purchase the property at fair market value for cash or other income-producing assets. Then, your spouse will earn the income from the cash or other assets while you both continue to enjoy the cottage.
The higher-income earner might also pay taxes for the lower-income spouse, make contributions to a spousal RRSP, and allow the lower-income spouse to claim all family tax credits such as medical costs and charitable donations.
Because different types of income are taxed at different rates in your non-registered portfolio, you want to ensure that your investments are getting the best returns and cash flow on an after-tax basis. In your non-registered accounts, interest income is fully taxable, just like any salary, net business income and other regular income, while Canadian dividends and capital gains receive preferential tax treatment.
The table “Top Marginal Tax Rates by Province” clearly shows the preferential tax treatment given to investment income in the form of eligible dividends and capital gains.
Dividends from Canadian corporations are grossed up on your tax return and a special dividend tax credit applies. This generally means that dividends are effectively taxed at a much lower rate than regular income. Capital gains are also effectively taxed at a lower rate — only 50 per cent of net capital gains are included in your income.
Since none of your investments are taxed as they grow within your registered accounts, the ideal scenario from a tax perspective would be to keep your fixed income investments in your RRSP to defer tax on the interest income and to hold your equity investments in your non-registered accounts to benefit from the preferred tax treatment of capital gains and dividends. However, there are many other factors you need to consider in setting up your registered and non-registered portfolios, including diversification among asset classes and your degree of risk tolerance.
Keep in mind, too, that you must terminate your RRSP before December 31 of the year in which you turn 71. At that time you should convert your RRSP to either a Registered Retirement Income Fund (RRIF) or a life annuity in order to defer the income and tax payable over future years. If you do not do this the funds will be fully taxable the year in which you terminate the RRSP.
If you’re 65 or older and not part of an employer-sponsored pension plan, you may be able to create income to qualify for the pension income credit and thereby save taxes. To do this, transfer your RRSP to a RRIF and then withdraw at least $2,000 per year between 65 and 71 to maximize your pension income credit.
Minimizing the tax on your investments takes careful planning and can be quite complex. However, a tax adviser who is familiar with your personal, family and business situation will be able to offer guidance as to which tax-planning strategies will be the most beneficial to you. CG
This article was prepared by FBC tax analyst Larry Roche. FBC has specialized in farm tax matters for 55 years, and now serves 50,000 members from branches in British Columbia, Alberta, Saskatchewan, Manitoba and Ontario. You can visit the FBC website at www.fbc.ca.If you have any questions about this article, please send an e-mail message to [email protected]or call 1-800-860-7011 tollfree