Three Ways to Cure Your “Tax Hangover”

Our succinct perspective on key investment and wealth-related issues.

As Canadians, we associate springtime with longer days, warmer weather, playoff hockey… and tax season.

It’s not surprising that many have an aversion to thinking about the latter: wealthy Canadians pay among the highest levels of personal income tax in the world.  In fact, as you read this letter, you may still be smarting from recently having written a large cheque to the folks at the Canada Revenue Agency (CRA).

So, for those experiencing this type of “tax hangover”, we recommend discussing the three strategies below with your trusted tax and wealth advisors.

Explore deferring taxes using your RRSP and/or an Individual Pension Plan (IPP)

You are likely familiar with the benefits of contributing to an RRSP: you receive a deduction today (typically, while you’re working, and your marginal tax rate is high) and pay tax on future withdrawals when you are retired (and your tax rate is lower). Meanwhile, the investment growth within your RRSP does not attract tax along the way. This is called tax deferral.

Already maximizing your RRSP contributions? You might want to consider an Individual Pension Plan (IPP). A popular strategy among high-income, 40-something corporate executives and owners of incorporated businesses, establishing an IPP is like creating your own defined benefit pension plan. Contributions to the IPP are tax-deductible to the corporation, and the capital grows tax-deferred (like an RRSP) until it is paid out as income in retirement (when your income tends to be lower). Depending on your personal circumstances, an IPP may make a good supplement to your tax deferral strategy or an alternative to RRSPs, as the allowable contributions are normally much higher.

Consider income splitting opportunities – like a spousal loan or a family trust

“Income splitting” is a strategy aimed at shifting taxable income from a higher-earning spouse (or family member) to a lower-earning one – thereby decreasing the household tax bill. But it’s important to be aware: CRA rules result in income being attributed back to the high earner if they simply “gift” assets to their spouse or minor child for the purpose of investment.

So, how can you decrease your family’s overall tax bill while staying on the right side of the CRA?

First, consider a spousal loan. This is a formal arrangement (including a signed contract) whereby a higher-income wife could loan funds to her lower-income-earning husband to invest in his name. The investment income on those funds can then be taxed at the husband’s lower marginal tax rate – decreasing the total tax the couple pays. But to make the spousal loan valid, the husband must pay a nominal prescribed rate of interest (currently 1% per the CRA), which counts as taxable income on the wife’s return. And he has to do the dishes.

A variation of this strategy may be to create a family trust. One application would be for a high-income-earning parent to loan money to a family trust that names himself, his spouse and two minor children as beneficiaries. The trust makes the requisite annual interest payment to the parent, so the investment income earned on the capital can be split among the family. This can result in significant tax savings, given that a portion of the income can be allocated to a spouse or child who may have little to no other taxable earnings. Creating a family trust is a more involved approach, entailing set-up costs, annual filings, and additional considerations (for instance, income allocated to minor children may be legally owed to them once they become adults). However, it may be worth the effort for wealthy families looking to mitigate taxes and fund certain large family expenses (such as a child’s school tuition, major trip, first car, or down payment on a home).

Give and receive (tax credits) – make the most of your charitable donations

Many wealthy families have two things in common: they want to use a portion of their wealth to benefit meaningful causes and they own publicly traded securities (like stock in their former employer) with a low cost base and an outsized unrealized capital gain.

Let’s say there’s a family in Ontario with employment income of $800,000 considering making a charitable donation at the end of the year. They own $500,000 of a stock with an adjusted cost base of $50,000. If they sold this holding to donate the resulting cash to charity, they would first trigger capital gain of $450,000 and a tax bill of $112,500. This would leave a donation of $387,500 for which (all else equal) they might expect to receive a refund of $170,000 on the taxes they have already paid that year.

But a more effective strategy exists to maximize the value of your charitable gift – as well as your tax credit. By donating shares to the charity “in kind”, the capital gains of this transaction would be tax-exempt and the tax credit would be based on the full value of the securities. This means that if the same Ontario family donated their shares in kind, their favourite charity would receive the full $500,000 (a 30% bigger gift!) while the family could expect to see their tax refund climb to $220,000.

While filing your taxes is never going to be your favourite sign of spring, having a thoughtful tax plan can mitigate the pain and allow your family to keep more of the wealth you earn. If you would like to learn more about these strategies, speak with your tax advisor – or feel free to reach out to the team at Focus for more information.