Which would you rather have: $750,000 or $1-million?
The question is that simple for Lorn Kutner, a tax partner at Toronto-based Deloitte. He says an effective tax strategy, implemented early in life, can boost investment returns by at least 25 per cent – risk free. Yet many investors don’t even bother.
“With a little bit of initial pain just to set up a tax plan, the benefits are huge. The key is to get over that initial burden. After you set it up, it runs by itself,” he says. “You reduce the overall family tax burden, your assets grow faster and you have more to invest each year.”
The trick, he says, is to know the tools available to most of us and get some help from a qualified financial adviser.
The most basic tool is the Registered Retirement Savings Plan. It’s important to know that an RRSP is not a tax exemption but a tax-deferral plan. It allows you to shelter your savings tax-free until a point in the future when you can withdraw it at a lower tax rate. The contribution limit for 2011 is 18 per cent of your previous year’s income up to a maximum of $22,450. If you don’t make the maximum allowable contribution, the difference can be accumulated and carried forward to future years. The total contribution room available for any year is listed on the previous year’s tax return.
The amount you contribute can be deducted from the highest level of your taxable income. For that reason, RRSPs provide the greatest advantage to people in high income brackets.
Although RRSPs are Federal government plans, most financial institutions administer them on your behalf and make their fees from the investments held inside. There are few limits on the types of securities you can hold in an RRSP – stocks, bonds, derivatives, mutual funds exchange traded funds (ETFs) – you name it.
How much an RRSP grows is generally determined by the holdings inside the plan but there is a tax trick to boost the amount you contribute. Here’s how it works: The contribution deadline for each tax year falls two months after the year’s end. That gives the plan holder time to establish what he can afford to contribute, and calculate the amount he would need to borrow to make the resulting tax rebate equal to the loan. For example, suppose your top tax bracket is 46 per cent (the maximum in Ontario). Let’s also suppose you can only afford to contribute $5,400. If you borrow an additional $4,600 and contribute a total of $10,000 you should receive a tax rebate near $4,600 – enough to cover the loan within weeks.
Over the past four years the tax toolbox has been expanded with the introduction of the Tax Free Savings Account. The TFSA is the same as the RRSP – only different. Investors can hold the same broad range of securities in a TFSA but unlike an RRSP, they cannot deduct their contributions from their taxable income. On the plus side: Unlike RRSPs, returns from investments in a TFSA are not taxed – ever.
When the TFSA was introduced three years ago, the maximum contribution was $5,000 with the limit to be raised by $5,000 each year. The total limit on the account is now $15,000 and will increase to $20,000 in 2012.
Mr. Kutner says the real strategy lies in the ability to balance the RRSP and TFSA for maximum efficiency. “You really need to step back, look at your personal circumstances and decided if you can’t put the maximum in both, what do you choose?” he says.
One strategy involves diverting contributions to a TFSA to avoid getting walloped with a huge tax bill if you have too much money in your RRSP – which could happen even if you don’t contribute the limit. When RRSP holders reach 71 years of age, they must transfer the holdings into a Registered Retirement Income Fund, or RRIF, and begin withdrawing minimum amounts set by Ottawa. Those amounts could push an individual’s taxable income into a high tax bracket and in some cases, Ottawa could refuse one of the most basic benefits intended for all Canadians. “If your income exceeds certain thresholds it starts to claw back your Old Age Security. Taking money out of a TFSA is tax free and doesn’t come into your tax return whether you’re putting it in or taking it out,” he says.
If you have the fortunate problem of having too much money in your RRSP and not enough contribution space in your TFSA, Mr. Kutner suggests getting the family involved. Contributions can be made to the RRSP of a lower-income spouse (or common-law partner) through a spousal RRSP. It’s important to note that a contribution to a spousal RRSP is deducted from the contributor’s allowable limit.
Another option is to open up another TFSA in the name of a spouse or an eligible child.
If the family plan doesn’t work, there are tax-saving strategies outside an RRSP and TFSA – in an unregistered trading account. While income from fixed income investments is taxed at 100 per cent, capital gains from equities are taxed at 50 per cent. That means the top tax rate for income is 46 per cent and the top tax rate for capital gains is 23 per cent. The top tax rate for income from eligible Canadian dividend stocks is 28 per cent. “What you would like to do is earn your highest rate income in either a TFSA or RRSP. Earn your capital gains and dividend income outside because you’re taxed at favourable rates,” says Mr. Kutner.
As a bonus, interest paid on loans to make investments in an unregistered account is also tax deductible.
The biggest risks to any tax strategy are misunderstandings and miscalculations, which could result in hefty penalties from the Canada Revenue Agency. Mr. Kutner says that’s why it’s so important to invest in good tax advice.
“Stop making the CRA your investment partner,” he says.