Think of all the money you've paid in income tax through the years. Now, think about how much that money could have generated in additional income.
That's the point Myron Knodel wants to drive home to Canadians as director of tax and estate planning with Investors Group in Winnipeg. Canadian investors too often overlook the potentially lucrative tax tools available to everyone, he says. "If you can have 30 years of tax deferral and have that money invested and working for you, when you project that out over a number of years it can be huge," he says.
Invest now, pay tax later
The most common tax-deferral tool is the registered retirement savings plan. RRSP contributions can be exempt from income tax in any given year, invested in just about anything, and grow tax free until funds are withdrawn – ideally when you are in a lower tax bracket. "You're saving tax now, and the future tax on that income won't come to roost until 20 or 30 years down the road. That's a significant amount of time" Mr. Knodel says.
Naturally, the higher an individual's tax bracket at the time of the contribution the bigger the tax savings, but Mr. Knodel says it could still make sense for Canadians in a low tax bracket to contribute. "You still get immediate tax relief, and you can use that money to get back in the investment process."
There are two big drawbacks with RRSPs. First, contributions are limited to 18 per cent of the previous year's earned income or $25,000 (whichever is less). Unused contributions can be carried forward to future years, but if the space is used up too early, the opportunity for tax saving in higher-income-earning years will be diminished. Second, contributions and gains in an RRSP are fully taxed upon withdrawal. If an RRSP grows too big, retirees could face higher marginal tax rates and even clawbacks in Old Age Security and the Guaranteed Income Supplement (OAS, GIS).
Never pay tax – ever
A tax-free savings account is the right tool for this job. TFSA contributions cannot be applied against earned income like an RRSP, but gains are never taxed. "If you feel your tax rate will be higher in the future, then the TFSA is the better route to go," says Mr. Knodel.
The TFSA contribution limit for the tax year 2016 is $5,500. The total cumulative contribution room since the program started is $46,500, making the TFSA a significant complement to the RRSP. Mr. Knodel warns, however, that the tax-free status of a TFSA is not carved in stone. He is concerned that a cash-hungry future government could change the rules and apply OAS and GIS clawbacks to wealthy account holders. "Are they really going to leave those TFSAs totally tax free?" he says.
Beyond RRSPs and TFSAs
Even if investors don't max out registered accounts such as RRSPs and TFSAs, they can find tax advantages in investing outside them. The biggest opportunity is the capital gains tax, which exempts half of the gains on most equities (such as stocks) from being taxed. Dividends from eligible stocks held outside a registered account can also generate a tax credit.
Gains from income-generating investments such as bonds are fully taxed, and that's why Mr. Knodel says they should take first priority in a registered account. "Once you have your asset allocation determined, you should try to concentrate your debt-type or interest-bearing investments in your registered accounts, and capital gains or preferentially taxed dividend investments into non-registered accounts. Otherwise the preferential treatment is lost."
One other advantage of holding equities outside a registered account is the ability to use capital losses to reduce tax on capital gains. "If there's a loss in your registered plans it's a total loss. If you have a loss in a non-registered account you have the ability to at least apply it against future gains, or if you had gains in the last three years, apply it [retroactively]," he says.
Income splitting strategies
One other tax-saving tool involves splitting taxable income with family members. "Where you have one family member who is at a high [tax] rate and one who is significantly lower, and there is a sharing of the benefits of that income, that is definitely something that needs to be looked at," says Mr. Knodel.
Parents of children under 18 can transfer up to $50,000 of income to a lower-income spouse for a maximum tax saving of $2,000 – effectively moving their income to a lower tax bracket. The federal income-splitting feature was introduced by the former Conservative government, and the newly elected Liberals have vowed to scrap it, so Mr. Knodel warns that 2015 may be the last year to use it.
Income splitting is allowed for retirees 65 or older drawing from their savings. If one spouse has a bigger nest egg than the other, up to one-half of eligible pension income can be taxed in the hands of the lower-income spouse. However, not all pension income – including some company pension plans – can be split prior to 65. That's when it's best to plan ahead by having the higher-income spouse contribute to a spousal RRSP, where contributions go into the lower income spouse's RRSP but the tax deferral can be used by the higher income spouse.
"If you or your spouse are going to retire prior to 65 and you are going to be drawing prior to that time, that's where the spousal RRSP would have an effect because you want to remove that money equally," says Mr. Knodel.