I miss my grandfather. He shared with me so many words of wisdom over the years.
He used say "Tim, before you criticize someone, you should walk a mile in their shoes. That way, when you criticize them, you'll be a mile away and you'll have their shoes." That advice has come in handy over the years.
He also used to tell me that "a penny saved in taxes is like a penny more in after-tax income earned." He would be proud that I'm not paying more in tax on my investments that I should.
Last week, I introduced the four pillars of tax-smart investing. These are to: (1) control the timing of income, (2) control the type of income, (3) control the location of income, and (4) control the offsets to income. Today, I want to talk about the second pillar: Controlling the type of income you earn on your portfolio. Here are six ideas to consider:
1. Understand your marginal tax rate
Your marginal tax rate is the amount of tax you'll pay on one additional dollar of income. That rate will vary, depending on the type of income. Interest income is the most highly taxed. Then there are capital gains and eligible dividends. When it comes to these, capital gains are generally taxed at more favourable rates if you have a higher level of income (typically over about $80,000; but it varies by province), and eligible dividends are generally taxed at lower rates when your income is lower. If you structure your portfolio to earn capital gains or dividends, you'll face less tax overall than if you earn interest. Keep in mind, the level of risk you take on will also be different and should be factored into your decision about the type of investments to hold. For a good summary of marginal tax rates, I like to visit this facts and figures page.
2. Returns of capital are tax-efficient
Some investments are designed to return your original capital to you over time. You won't face tax on a return of capital, and so this type of cash flow is very tax-efficient. Keep in mind that this is really a deferral of tax since you'll pay tax later, when you ultimately sell the investment, but the money is better in your pocket for the time being than the taxman's. If you happen to own private company shares, you can extract your "paid-up capital" (a cousin to your adjusted cost base) tax-free from your company, which can be better than dividends.
3. Manage clawbacks of OAS benefits
If you receive Old Age Security (OAS) benefits and your income in 2014 is over $71,592, then you'll have to repay part of your benefits. You'll repay 15 cents for every dollar of income over $71,592 this year. If you earn eligible dividends, those dividends will be grossed-up for tax purposes, so that you'll report $1.38 of taxable dividends federally for every $1 of actual cash dividends, and this will make a potential OAS clawback problem even worse. Again, don't let the tax tail wag the investment dog: If dividend-paying stocks are right from a risk perspective, they may be best for you. But understand the tax implications.
4. Share buybacks can be better than dividends
If a company has excess cash and chooses to buy back shares, you'll face tax on a capital gain rather than dividends, which could be better for you than dividends if you're in a higher tax bracket, and provided you don't need the income.
5. Sell shares on the right side of the ex-dividend date
You have some control over whether you'll face tax on capital gains or dividends by choosing the time of your sale. If you sell a security before the ex-dividend date you'll realize capital gains only, which could be best if you're in a higher tax bracket. If you sell on or after the ex-dividend date you'll receive dividends, which could be best in a lower tax bracket.
6. Consider a back-to-back prescribed annuity
Here's how: Consider taking some of your capital invested in interest-bearing investments and buy a prescribed annuity. A portion of each annuity payment will be taxable interest, but a portion will be a tax-free return of capital. You'll face less tax and put more in your pocket. Then, take some of the additional cash flow from the annuity to purchase a life insurance policy (back-to-back with the annuity) that will pay out on your death, replacing all or some of the capital invested in the annuity.
Next time, I'll continue this discussion on the pillars of tax-smart investing.
Tim Cestnick is president of WaterStreet Family Offices, and author of several tax and personal finance books.
Tim Cestnick