It’s difficult for anyone-even your accountant or financial advisor-to keep up with changing tax laws and incentives. And that means you’re probably paying more taxes than you need to. While time has run out for 2004 tax savings, you can act now to make things right next April-and for years to come. Step 1: ask your advisor about these eight underused tax strategies.
Lend in the family
Income splitting with a lower-income spouse is one of the few legal ways a family can reduce its tax burden. So why not take advantage of it? Indeed, loaning money to a lower-income spouse or another family member is even more attractive since Ottawa introduced a prescribed interest rate. In the past, attribution rules required you to report any investment income your spouse earned on money you lent him or her. Now you can charge your spouse a set interest rate on money you lend, (currently 3%), and any resultant investment gains are claimed on his or her returns-possibly at a lower tax rate.
Let’s say you lend $10,000 to your spouse to invest, at borrowing cost of 3%. You have to report that interest as income, but any appreciation in the investment, say, 7%, would be taxed in the hands of your spouse. Your spouse deducts the interest paid, thus paying taxes on the net amount (4%) of the investment income. Over time, as investment returns continue to exceed the cost of the loan, more of the investment income shifts to the lower-income spouse, where it grows tax-effectively. To make this strategy work, there must be a written loan agreement in place and your spouse must pay interest charges before January 30 each year. Bonus: the interest rate stays at 3% as long as there’s a balance outstanding.
Invest in education
Two years ago, an RBC Financial Group survey revealed that just 24% of Canadians were aware of the existence of registered education savings plans (RESPs), let alone their tax advantages. And awareness levels haven’t improved much since then, says Jim Rogers, president of Rogers Group Financial in Vancouver. The fact is, for every $2,000 you invest each year in an RESP, Ottawa will kick in an additional $400. “It works out to a 20% return immediately,” says Rogers.
Still, Ottawa’s generosity tops out at $7,200 per beneficiary. Since the contribution is made with after-tax dollars, you can’t write it off. But the growth on the money is tax-deferred until the money is withdrawn. Withdrawals are taxed at your child’s tax rate; since students have little other income, they pay little or no taxes.
Go with the flow
Flow-through shares are a great way to combine a business opportunity with tax savings. These are equity investments in venture-oriented companies-often resources or biomedical firms-that need cash for research and development or exploration. Such companies receive tax write-offs from Ottawa in the hopes their discoveries will expand the Canadian economy. Those tax breaks are “flowed through” to the investor, whose investment is tax-deductible.
Cut your cap losses
Everyone has a few dogs in their portfolio. So why not sell them to offset capital gains taxes on your non-registered investment earnings? “If you know you have gains in your portfolio,” says Keith McLaughlin, an investment adviser with BMO Nesbitt Burns in Toronto, “you can go hunting for capital losses to offset them.” In fact, any losses you’ve incurred in the past three years can be claimed to offset current gains, too.
Seek the best shelter
Not all investment returns are equal. You’ll pay your full marginal tax rate on the interest earned from fixed-income investments such as bonds, GICs and term deposits, for example, while equity-based products are taxed at a lower rate. Stock dividends, for example, qualify for the dividend tax credit. So choose carefully what investments to protect in your registered portfolio. For greater tax efficiency, allocate your most highly taxed investments to your registered portfolio; leave lesser-taxed holdings in your non-registered account.
When it comes to investing, life insurance isn’t usually at the top of the list. But maybe it should be. A universal life policy is a versatile investment vehicle that gives lifelong insurance protection to your family and tax-deferred growth for your savings.
Here’s how it works. You make a monthly payment for the term of the insurance policy (e.g., 10 years). Part of your payment covers the insurance premium, and the rest goes into a tax-sheltered investment fund of your choice. When you die, the beneficiary receives the insurance payout and the investment funds tax-free. “This kind of insurance can help defray some of the taxes on death,” says Stephen Thompson, a tax specialist with Wilkinson & Company LLP in Ottawa. Until that fateful day, you can withdraw funds-which will be taxed as income-to supplement your retirement income or meet short-term financial emergencies.
Opt for IPPS
Conceived in 1991 with business owners in mind, IPPs still remain underexploited. But if you’re aged 45 to 50 and have maxed out your RRSP, this defined-benefit plan is a great way to put away large chunks of cash in a tax-sheltered environment. Set up for you by your company, the plan’s benefits are twofold: contributions are tax-free to you and a tax-deductible expense for your company. Investments held in the plan grow and compound tax-free, until you withdraw money when you reach retirement.
Sound too good to be true? There are caveats. First, there are limits to your contributions, which are typically based on your age, tenure and salary. Second, as a defined-benefit plan, Canada Revenue Agency currently requires an IPP to grow by 7.5% annually. If your plan depreciates, your company must top up the account. If your plan returns more than 7.5%, your contribution limit drops in the next year.
Freeze your estate
If you want to bequeath your business to your family with minimal tax consequences, consider an estate freeze. The tax liability will be limited to the present value of the assets; any future capital gains will be taxed in the hands of the new owners. One common way of performing a freeze involves a reorganization of the firm’s share ownership. First, you as the owner exchange your common shares for voting, redeemable preferred shares of the same value. A new class of common shares is created for your children or grandchildren. Any future growth in the business accrues to their shares, and any future capital gains tax liability will be deferred until those shares are sold. Because your preferred shares have voting rights, you still control the business. Preferred shares can also provide dividends for retirement income or be redeemed.