The 3 Pillars of Tax-Efficient Investing | FBC, Canada's Farm & Small Business Tax Specialist

The 3 Pillars of Tax-Efficient Investing

If you have a portfolio of off-farm investments, you should plan to review those investments on a regular basis to ensure you are 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 3 key pillars of tax-efficient investing:

  1. Defer
  2. Split
  3. Convert

Income Deferral

The benefits of income deferral as a tax planning technique are two-fold: 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 and you will be 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 sizeable 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.

If you invest in the flow-through shares of Canadian companies that explore for minerals, oil or gas, you receive about a 92% write-off of the purchase price, with deductions for the remaining 8% over the following 2or 3 years. Your share cost is deemed to be nil for tax purposes.

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 losses to offset capital gains in any of the prior 3, current, or any future tax years.

Income Splitting

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 in income splitting result 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 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.

You could loan funds to family members other than your spouse to invest in assets that will generate capital gains, which are not subject to attribution rules.

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. 

Income Conversion

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.

Top Marginal Tax Rates by Province - Combined Federal and Provincial (%)
 
  BC AB SK MB ON QC NB NS PEI NL
Ordinary income 43.70 39.00 44.00 46.40 47.97 48.22 43.30 50.00 47.37 42.30
Non-eligible dividends 33.71 27.71 33.33 39.15 34.52 36.35 30.83 36.21 41.17 29.96
Eligible dividends 25.78 19.29 24.81 32.26 31.69 32.81 22.47 36.06 28.70 22.47
Capital gains 21.85 19.50 22.00 23.20 23.98 24.11 21.65 25.00 23.69 21.15


Note: Interest would be under "ordinary income" for different types of investment income.

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% 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.

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 the 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 over the age of 65 and not part of a 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 $2000 per year between 65 and 69 to maximize your pension income credit.

Minimizing the tax on your investments takes careful planning and can be quite complex. However, a tax advisor 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.

"If all the economists were laid end to end, they’d never reach a conclusion." — George Bernard Shaw