I've been talking recently about the four pillars of tax-smart investing: (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 chat about the third pillar: The location of income.
When I told my wife Carolyn about the topic this week, she said "the location of income should be very simple: in my bank account." Then I told her that the location of income has less to do with where the money ends up, and more to do with who pays the tax on the income, if anyone. She wasn't as excited by that concept.
Location. Location. Location. Perhaps you thought this matters only in real estate. Not so. The location of your investments has a big impact on how much tax you'll pay. Common "locations" include: Your personal hands, your spouse's hands, the hands of your children or other family, inside a registered retirement savings plan (RRSP) or registered retirement income fund (RRIF), inside a tax-free savings account (TFSA), or inside a corporation, family trust, or partnership.
Speaking of location, people often ask whether holding assets in another jurisdiction can save tax. As a general rule, this won't help you because you'll face tax on your worldwide income if you're a resident in Canada, and our tax law and recent court decisions are tough on taxpayers who try to use offshore trusts or corporations to avoid tax.
Consider the following ideas to optimally locate your investments to save tax:
1. Use registered plans when earning interest
To the extent you own interest-bearing investments, hold them inside a registered plan (RRSP, RRIF or TFSA) so that the interest, which is otherwise highly taxed, is sheltered from the taxman. This is not to say that equities, which you're holding for capital growth, should not be held in a registered plan, but not if it means you then have to hold interest-bearing investments outside the plan.
2. Consider a corporation to hold investments
By holding some or all of your non-registered investments inside a corporation you won't face tax personally on the investment income. This could reduce a clawback of government benefits such as Old Age Security, minimize U.S. estate tax on U.S. securities, and minimize probate fees. In some provinces, in some years, the tax you'll face on investment income inside the corporation could be less than what you'd pay personally if you're in the highest tax bracket.
In 2014, it's the case that capital gains and interest earned in a corporation offer no benefit over earning the amounts personally, but certain dividends earned in a corporation, rather than personally, may leave you better off in some provinces.
3. Place assets in trust
Putting assets in trust can provide you with continued control over the assets while passing the tax bill on any investment income to the beneficiaries of the trust – if you structure it properly. You do have to be concerned about the attribution rules in our tax law, but if you lend money to the trust and charge interest at the prescribed rate on the loan, or are careful about which beneficiaries are entitled to the income (adult children only, for example) you may be able to reduce the overall tax of the family.
4. Transfer assets to family
I'm talking here about splitting income by moving assets to the hands of family who will pay tax at lower rates than you. If you do this properly you'll avoid the attribution rules in our tax law and you'll save tax. You might also gain a measure of asset protection and reduce taxes and probate fees on death when moving assets out of your name.
5. Avoid superficial losses and average costs
If you own a security and sell it at a loss, your loss could be denied if you reacquire that security in the 61-day window that starts 30 days prior to, and ends 30 days after, your sale. By repurchasing the security in the name of a child you can avoid this superficial loss. Also, when you buy a security at different points in time, your adjusted cost base (ACB) on each purchase is averaged to arrive at a weighted average ACB per share. Any future gain or loss will be based on this average ACB.
If you want to avoid averaging your cost amounts, perhaps to keep flexibility in the ACB that will be used when selling the security, consider making subsequent purchases in the name of your corporation, a family member, or your family trust.
Tim Cestnick is president of WaterStreet Family Offices, and author of several tax and personal finance books.