The Globe and Mail

It's payback time if you're a senior who's still peeved at the federal government for cracking down on income trusts.

The income trust sector has struggled since Ottawa announced a little over a year ago that a new tax will be levied on trusts starting in 2011. Remember how the feds tried to sweeten the move against trusts? They told seniors that they would be able to use pension income splitting to reduce the amount of income tax they pay.

Here's where the payback comes in. With the 2007 tax returns they'll soon be completing, seniors are going to be in a position to start putting income splitting to work. There's more to be done than just income splitting for seniors who want to save taxes, however. Let's summarize this supplementary tax planning as follows: Think dividends.

The goal is to substitute dividend-paying common or preferred shares for bonds and guaranteed investment certificates in your non-registered investments. Before we look at how to do this, let's review how income splitting works.

Income splitting is where a higher-income spouse or common-law partner takes up to half of his or her eligible pension income and allocates it to the lower-income person for tax purposes. The net result should be a lower combined tax bill, based on the fact that the lower-income spouse pays somewhat more in tax while the higher-income spouse pays considerably less.

The sources of income eligible for pension income splitting include payments out of registered retirement income funds and lifetime annuity payments flowing from a registered pension plan, registered retirement savings plan or a deferred profit-sharing plan. All of these types of income can be split by those who are 65 or older, but company pensions can be split by those under 65.

Gena Katz, executive director of taxes at Ernst & Young, said there will be a line in the 2007 tax form where people can specify how much pension income they want to transfer to a spouse. There will also be a line where the recipient says how much is being added to his or her income. "It's pretty straightforward," Ms. Katz said. "People should be able to do it easily."

The obvious limitation on pension income splitting is that it doesn't apply to funds generated in non-registered investment accounts. This brings us to a dividend strategy suggested by Ted Rechtshaffen, president and chief executive of TriDelta Financial Partners.

Mr. Rechtshaffen notes that the tax rate on dividends is far less than it is on interest earned from bonds and GICs, and it's lower than the tax on capital gains for many people. Example: Someone earning $50,000 a year in Ontario would pay 31.2 per cent on regular income, 15.6 per cent on capital gains and just 8 per cent on eligible dividends (those from large companies).

To exploit the favourable tax rate on dividends, Mr. Rechtshaffen suggests taking money in high-interest accounts, GICs, bonds and other non-registered investments that pay interest and moving it into preferred shares issued by the major banks.

A high-interest account might pay around 3.75 per cent today, whereas bank preferreds offer in the area of 5.25 per cent. This differential is even more pronounced on an after-tax basis, where the return on the GIC falls to about 2.6 per cent for someone with an income of $50,000 and the return on the bank preferreds to about 4.9 per cent. Another perspective: a senior with income of $50,000 a year would keep $68.80 of every $100 he or she earns from the high-rate account and $92 of every $100 in dividend income.

Preferred shares are worth looking at as a source of dividend income because they're more conservative than the common shares that people generally key on when they think of stocks. First off, preferreds are thought of as income-producing investments and are far less volatile in price than common shares (they can still rise and fall in price, however). Preferred shares also offer an additional level of security in that troubled companies will save money by suspending the common share dividend first.

Let's be clear - there's no deposit insurance for preferred shares like there is for high-interest accounts and GICs. Still, it's virtually unheard of for investment-grade preferred shares to miss a quarterly dividend payment. Big bank preferred shares are all investment grade, which means that credit rating agencies scored them high enough to meet the requirements of pension funds, insurance companies and other conservative investors.

There are 38 different bank preferred share issues listed on the Toronto Stock Exchange, according to Globeinvestor.com. For some ideas on which might be suitable for conservative investors, let's consult James Hymas, president of Hymas Investment Management and a top expert on preferred shares.

Mr. Hymas highlighted the following:

Canadian Imperial Bank of Commerce Series 26 (CM.PR.D). These shares pay annual dividends of $1.44 and have traded around $25.35 this week, which means a yield of 5.7 per cent. Mr. Hymas said CIBC can redeem these shares at its discretion in May, 2012, for $25, and he thinks there's a reasonable chance of this happening. This would mean a slight capital loss, which you'd have to weigh against the high yield.

National Bank of Canada Series 16 (NA.PR.L). National Bank announced a fourth-quarter loss as a result of exposure to asset-backed commercial paper, and its preferred shares have not been immune. At current prices around $21.40, the dividend of $1.21 yields 5.6 per cent.

Royal Bank of Canada Series W (RY.PR.W). The annualized dividend of $1.23 yields about 5.3 per cent based on this week's pricing in the range of $23.30.

All of these preferred share issues are what's known as perpetuals, which means they can be redeemed at the discretion of the issuer and have no fixed maturity date. These shares all have potential redemption dates coming up in the next three to five years or so, but Mr. Hymas sees the CIBC shares as being the only ones with a decent chance of this happening.

Investors buying these shares have to be prepared for the possibility that the price can fall as well as rise. Rising concern about Canadian bank exposure to the subprime mortgage problem in the U.S. could push preferred shares lower, as could rising interest rates. The price of a preferred share is not especially important, however. What matters is whether the issuing company is able to pay the dividend.

As tempting as dividends are on an after-tax basis, many retirees won't be comfortable with a portfolio consisting entirely of preferred or common shares. Mr. Rechtshaffen suggests these investors view their registered and non-registered investments as a whole and then decide on overall percentages for bonds and stocks. Stocks go into the non-registered portion, where any dividends would be eligible for the dividend tax credit. Bonds and GICs go in the registered portfolio, where income-splitting is available to reduce taxes.

Income splitting will get lots of attention as we head into the tax-filing season, in part because it's Ottawa's tradeoff to seniors for cracking down on income trusts. Don't forget about dividends, though. They're just as much a friend of retirees.

TAX SAVINGS FOR SENIORS

Seniors filing their taxes for 2007 will be able to take advantage of pension income splitting, which was introduced by Ottawa at the same time as it cracked down on income trusts. Additional tax savings can be obtained by getting as much income as possible from dividends rather than bonds and GICs. Here's an example of how income splitting and dividends can work together.

Our example: Joe and Mary are a couple, both over the age of 65. Joe has income of $80,000 per year from a company pension and a registered portfolio, while Mary has income of $20,000 from various sources. With income splitting, Joe will allocate $30,000 of his pension income to Mary and thereby equalize their incomes at $50,000 apiece.

Joe's marginal tax rate

2006/without income splitting: 43.4% on $80,000 ($34,720)*

2007/with income splitting: 31.2% on $50,000 ($15,600)*

Mary's marginal tax rate

2006/without income splitting: 21.1% on $20,000 ($4,220)*

2007/with income splitting: 31.2% on $50,000 ($15,600)*

Income splitting would result in a tax saving of ($38,940 - $31,200) = $7,740

Joe also has an unregistered portfolio of bonds and GICs that produces $10,000 per year in income. Let's see how he can boost his tax savings if he were to get his income from dividends instead, assuming an income of $50,000

Tax rate on interest and regular income

31.20%

($3,120)

Tax rate on dividends

8%

($800)

* For illustration purposes. Actual tax payable will depend on personal circumstances.