The adage that nothing is certain but death and taxes is actually not quite correct. Death remains everyone’s destiny, but some taxes can be postponed for one’s entire life or shifted beyond one’s life to people in whose hands actual amounts payable to government may be negligible. Taxes can also be minimized by investments that postpone amounts payable, investments in assets that have relatively low tax rates, income splitting with a spouse or children, and changes in the nature of income or how business is organized. What is required to achieve these tax savings is careful control of investments, employment income, and bonuses in order to achieve income averaging where possible and, for investments, cash flow shifting where it is lawful. None of the following discussion of tax management presumes or suggests actions that are not in compliance with Canadian tax law.
Let’s look at tax management for the individual taxpayer with a list of the easiest things almost anyone can do to cut a tax bill:
1. Use RRSP space to reduce current taxes. In 2007, the Registered Retirement Savings Plan contribution limit is the lesser of 18% of earned income in 2006, or $19,000.
RRSPs have the effect of deferring income until money is paid out of the RRSP either as a lump sum, an annuity, or as payments from a Registered Retirement Income Fund. There is a catch, however, for while investment income generated inside an RRSP grows with no taxation, all tax preferences on capital gains and dividends are cancelled when the money is paid out as ordinary income at full tax rates.
Adept use of RRSPs thus requires the taxpayer to decide if potential cash flow from investments is better left outside of the plan so that capital losses can be claimed against other gains and whether dividends can be taken at relatively low tax rates. Clearly, tainting investment income by generating it within an RRSP just a year or two from retirement, when it will emerge from the RRSP in fully taxable form, is unwise. No two tax situations are identical, but a taxpayer can estimate whether it is better to shelter or not by comparing the amount of present tax saving, if any, by generating investment cash flows within an RRSP (the pro’s of sheltering) with the cost of sheltering in the form of loss of tax preferences for capital gains and dividends. This comes down to how much tax you save with an investment in an RRSP just a few years from retirement versus how much more you may have to pay in tax when you boost the tax payable on capital gains and dividends within the RRSP. Of course, for taxpayers who prefer to invest solely in bonds and GICs, there is no loss of tax preferences since those assets have none.
The money in an RRSP can pass to a spouse after the death of the first spouse without any immediate tax. The funds that pass to the surviving spouse’s RRSP or Registered Retirement Income Fund produce a deduction that offsets the income inclusion with the result that no tax is payable at the time of transfer. If RRSP or RRIF funds are left to a dependent child or even a grandchild, the sums transferred can either be taxed in the hands of the child or used to buy a term annuity to age 18, thus spreading out the tax obligation, adding some investment return within the annuity, and avoiding the tax burden that comes with a single, lump-sum payment of income.
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2. Use a spousal plan to split RRSP income. The most common strategy is to contribute a part of one’s annual RRSP limit to a spousal plan. If the receiving spouse is likely to have a lifetime income appreciably less than that of the giving spouse, then there are two vital results. First, the spouse will wind up with a significant amount of wealth which, when taken out of the RRSP in a RRIF or annuity, will be taxed at a lower rate than if no transfer had been done. Second, the spousal RRSP split may enable the family to preserve the full amount of Old Age Security payments that are subject to clawback.
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3. Average CPP benefits. There are other splitting strategies as well. Couples, each of whom is 60 year of age or older, can swap Canada Pension Plan benefits when received. Spouse A transfers a part of benefits to Spouse B and Spouse B transfers the same percentage of benefits to Spouse A. This has to be done through Human Resources Development Canada.
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4. Split income with children through a Registered Education Savings Plan. Children can be part of splitting strategies too. If a parent contributes to a Registered Education Savings Plan, there is no tax deduction, but income earned within the RESP grows without tax until withdrawals are made, at which time the money taken out is taxed in the hands of the child who is pursuing post-secondary education. If the child is in a low tax bracket, this strategy effectively splits income into a lower tax bracket. Note that the Canada Education Savings Grant of the lesser of 20% of amount contributed each year to the RESP or $400 goes to the beneficiary of the plan in post-secondary education.
If the child - or grandchild for that matter - fails to pursue post-secondary education by age 21, up to $50,000 of the RESP funds can be transferred to the RRSP of the contributor provided that the RESP has been in operation for 10 years or more. The amount of the RESP balance available for transfer over $50,000 or any sums not transferred to the contributor’s RRSP can be taken out with a 20% tax on the amount taken on top of regular taxes, a hefty sum but, in theory, a way to make up for taxes not paid while the money was sheltered with the RESP.
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5. Have the higher income spouse pay household expenses. The higher income spouse can also pay the income taxes of the lower income spouse. Since the amount paid on behalf of the lower income spouse is not invested (it goes directly to the government), there is no need to attribute any income back to the paying spouse. The lower income spouse can then invest the amount of tax saved.
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6. Employ spouse or children. A person with a business can employ a spouse or children and pay them wages or salaries appropriate to the work they do. The pay must be reasonable in terms of what they do for the business. There is some flexibility in this, but it is unlikely that paying a five-figure salary to a six year old to lick envelopes would pass muster. It is unwise to be very aggressive in making use of this form of income splitting.
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7. Loan money to a lower-income spouse to make an investment. This strategy will work provided that the spouse borrowing the money pays interest of at least the rate prescribed by the Canada Revenue Agency or, if it is less, the going commercial rate. If no interest is charged, then attribution rules may be triggered and wind up taxing the proceeds of investment in the hands of the spouse making the loan.
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8. Create a corporation to carry on an active business. Small corporations have a preferential tax rate of 17.62% on the first $400,000 of corporate income for Manitoba - rates vary by province - and though taxes catch up to amounts held within a corporation when the money is finally paid out, funds will have had a tax holiday while within the corporation.
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9. Blend interest into the sale price of an asset. A taxpayer can avoid taxation on interest charged when property is sold but not paid in full at time of sale or transfer. Interest on a loan is taxed at full marginal rates. But if a sales agreement is structured to include the interest in the price of the thing being sold, then the difference between price and cost will be taxed as a capital gain.
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10. Reinvest interest income in common stock or preferred shares that pay dividends that have lower tax rates and that, if sold at a loss, can produce deductions against other capital gains.
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11. Use life insurance to convert a growing body of money into the property of family members. Because money that is used to pay insurance premiums is already tax-paid, the benefits that emerge after the policyholder’s death are tax-free in the hands of a named beneficiary. To avoid costly and time-consuming probate, it is essential to name the beneficiary or beneficiaries - a simple procedure that the insurance company can handle in a few moments, and, after death, money will have become the property of the beneficiary in full. One can use the same procedure to provide tax-paid money to pay taxes that may be due on one’s own final tax return.
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12. Invest in devices, such as tax-efficient mutual funds or natural resource income trusts, which return some of their earnings to unit or shareholders in the form of return of capital. There are no taxes on capital per se, so the return of capital is regarded as tax-free. Such investments become annuity-like in that they pay a return that includes some of the original contribution. In tax-efficient mutual funds, careful construction makes it possible to pay money to unit holders out of capital while maintaining normal distributions. In the case of natural resource trusts, capital is returned to compensate for the depletion of the asset base. In each case, however, a return of capital reduces the adjusted cost base and therefore raises the potential capital gain from sale of the asset prior to exhaustion of the capital. This tax deferral can make future tax planning more complex.
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13. Buy convertible bonds that allow a switch from income producing interest coupons to common shares that can produce capital gains and dividends. This switch may be accompanied by higher volatility of the asset because dividends are less secure than bond interest and because bondholders rank before preferred shareholders in the event of insolvency of the issuer. Convertible bonds are more complex to manage than are straight bonds, but they change the character of investment income very effectively.
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14. Make sure children with earned income file a tax return. Even income from a paper route or from bagging groceries at a supermarket can be used to create RRSP space that can be used in later years when, with a substantial income, the child - now an adult - faces high tax rates and can save a lot of money by using up that space. In some cases, filing a return showing low income may make it possible to claim certain low-income provincial tax benefits or to obtain a GST low-income credit for children over 19. The Manitoba Cost of Living Credit can be paid to children over 18.
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15. Claim medical expenses proficiently. To be deductible, medical expenses, which can include payments to a wide variety of service providers that range from MDs to dentists, registered nurses, psychologists and beyond, must exceed 3% of net income or, if one’s income is over $62,800, a flat $1,884 (the amount changes each year). But expenses are claimable within any 12-month period ending in the tax year for which a claim is made. As well, they may include hospital charges, drug costs, nursing home bills, care of persons with severe and prolonged disabilities, guide dogs for the blind including cost of purchase and upkeep (including vet bills), eyeglasses, hearing aids, dentures, costs of moving to accessible housing, cost of a training course related to the care of a disabled relative, and medical appliances that range from crutches, canes and wheelchair lifts, to insulin needles and blood monitoring equipment.
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16. Make a vow of perpetual poverty. Members of religious orders who take a vow of perpetual poverty can deduct an amount equal to his or her earned income and an amount equal to the pension benefits in the year if these amounts were paid to the order. Where this claim is made, the claimant cannot also claim a charitable donation tax credit for the year. This procedure is not as silly as it may sound, for retirement into a monastery or another form of contemplative life with abundant reading and prayer time and a planned way of life is desirable to some people.
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