Tax tips for Americans in Canada

Recommendation No. 1: Seek advice on reporting requirements

Most countries, including Canada, do not tax on the basis of citizenship. For example, Canadian citizens who live in Canada pay tax in Canada on the taxable income they earn. If a Canadian citizen moved abroad a few years ago, with no continued ties to Canada, it is most likely this individual would be considered “non-resident” and would have no tax reporting obligation to Canada. In other words, Canadians are taxed based on residency.

The U.S. tax system is different as it treats all U.S. citizens as U.S. residents for tax purposes, no matter where they live in the world, including Canada. Many U.S. citizens live in Canada and are resident here. A U.S. citizen has to pay tax in Canada on taxable income if they are resident for Canadian tax purposes.   Canada and the U.S. have entered into various agreements (i.e. tax treaties) to address taxation differences and to largely avoid double taxation.  

The Internal Revenue Service (IRS) in the U.S. has been trying to crack down on American taxpayers using financial accounts held outside of the U.S. to evade taxes. For example, the U.S. introduced the Foreign Account Tax Compliance Act (FATCA), signed into law on March 2010, with the objective of identifying taxpayers evading taxes. To do that required co-operation from other countries to provide information.  

The U.S. effectively told Canada that if it did not comply, then all income from U.S. investments would be subject to a 30 per cent withholding tax. This threat of withholding was for both registered and non-registered investment accounts.

Previously, Canada was not required to withhold any tax on U.S. investments held in registered accounts. For non-registered accounts, the negotiated tax treaty had withholding rates on U.S. dividends at 15 per cent and nil for US interest income.

Earlier this year, Canada and the U.S. signed an Intergovernmental Agreement (IGA) regarding FATCA, in which Canada agreed to pass laws requiring that, primarily through financial institutions, that annual reports be made to the Canada Revenue Agency on specified accounts held in Canada by U.S. persons. The agreement brings Canada, via the CRA, into a reporting agreement to satisfy FACTA.

Under the agreement, the U.S. has agreed not to apply the 30 per cent withholding tax on registered accounts, such as RRSPs, TFSAs and RESPs, and to maintain the existing withholding rates for non-registered accounts.

Effective July 1, 2014, an amendment to the Canada Income Tax Act adopting Canadian tax regulations related to FATCA.   Also beginning in July 2014, financial institutions have new requirements to report to the CRA, not the IRS. Clients of financial institutions will be required to complete additional mandatory questions for all non-registered accounts. New account-opening forms will require you to state if they are a citizens of Canada, and if they are a citizen of the U.S. Another question is, “Are you a U.S. Person (Entity) for tax purposes?” Certain legal entities must answer a new classification question relating to active or passive entity.

For the purposes of FATCA, here are some examples of who is deemed a U.S. Person (Entity):

  • U.S. citizens, include persons with dual citizenship, U.S. residency,
  • Any person who meets the IRS “Substantial Presence Test of U.S. Residency,”
  • U.S. resident aliens (Green Card holders who do not have U.S. citizenship),
  • Persons born in the U.S. or who hold a U.S. Social Security Number (SSN) or U.S. Tax Identification Number (TIN) or a U.S. Place of incorporation or registration

Financial firms have a mandatory obligation to provide this information to CRA. CRA will begin sharing relevant information pertaining to the agreement with the IRS starting in 2015.

For the majority of Canadians, this is a non-issue. For the approximately one to two million people in Canada that would be deemed a U.S. Person (Entity), it reinforces the need to have all of your tax filings up to date with both the IRS and CRA.

Sharing information electronically between CRA and the IRS will enable the IRS to obtain information on U.S. Persons (Entities) that have not fulfilled their reporting obligations.

Other indicators must also be reviewed, including U.S. address (residence, mailing, in-care-of, or interested party), U.S. telephone number, standing instructions to transfer funds to an account held by the client in the U.S., a power of attorney or signatory authority granted to a person with a U.S. address.

Many snowbirds have asked me what their requirements are under FATCA. Reviewing the “Substantial Presence Test of US Residency” on the IRS website is a good starting point. A wealth advisor should have enough knowledge about FATCA to make sure your accounts are documented correctly and that they are asking you the right questions.

I recommend every client who is not sure if they have a reporting obligation to consult with an independent tax advisor to determine if they are a U.S. person for tax purposes. It is important that the accountant you approach has knowledge in these areas to be able to provide you appropriate advice.

Effective July 1, 2014, financial institutions are required by law to report annually to CRA on accounts where a client is unwilling or unable to provide documentation for FATCA, one of more U.S. owners are specified ”U.S. Persons,” undocumented account holders for FATCA purposes, and passive entity with one or more controlling persons that are specified “U.S. Persons.” The information that must be sent to CRA includes name, address, TIN/SIN and total account value.

If you are not sure if you have a reporting obligation, we encourage you to speak with your wealth advisor who should be able to communicate with your independent tax professional, and together ensure your financial accounts are documented correctly and you are fulfilling your reporting requirement, if any.  

This article is intended as a general source of information and should not be considered as personal investment, tax or pension advice. We are not tax advisors and we recommend that individuals consult with their professional tax advisor before taking any action based upon the information found in this publication.

Investments for retirement income key

Fewer Canadians can count on large defined-benefit pensions or fat nest eggs 

The Investment Industry Association of Canada (IIAC) issued a report on March 18, 2014 titled “Canada’s Investment Industry:  Protecting Senior Investors.”  The report noted the challenge of defining who is a senior.  Rather than picking a specific age, the IIAC used the term “senior investor” to include people who have retired or are nearing retirement.  The report also noted that there is only a limited number of Canadians who are not concerned about investment performance.  As time goes on, fewer Canadians will be able to retire with a large defined benefit pension plan or significant financial assets. 

Most Canadians who are retired, or are approaching retirement today, need to appropriately manage their investments.  Investment performance is composed of two parts, the changes in the value of the investments and also the income stream.  More and more people are looking for investments that generate an income.

The 2011 Census noted that almost 15 per cent of the population was 65 or older.  The first wave of baby boomers, born between 1947 and 1966, began hitting 65 in 2012.  The report noted that demographic studies indicate that one in four Canadians will be 65 or older by the year 2036.  

Seniors are living longer in retirement than ever before.  If a client retires at age 60 and lives to age 90 then their retirement time horizon is thirty years.  For most retired clients, it is a daunting task to try to map out an investment strategy to last the remainder of their lifetime.  Most seniors want to retire and not get bogged down by looking at their investments all the time. 

I have a few suggestions for seniors approaching retirement or those already retired.  First, find a qualified financial advisor who you feel has experience, but also one that you can work with for a reasonable period of time.  Together you can work on the suggestions below. 

The first step I take with new clients is ensuring that I understand their complete financial situation.   I suggest that a net-worth statement be prepared, listing all of your assets and liabilities.  The more detail you can provide, the better.  As an example, if you have certain assets listed, adding in the original cost of those assets helps an advisor map out the tax component for any future dispositions.   If you have a previously prepared financial plan, this is an excellent document to provide to your advisor.  Often, I see people bring in their previous financial plan, it is not so much a financial plan as a simple illustration or concept. 

A very important step is the preparation of a budget.  The best budgets are those that are prepared on a monthly basis.  Listing all of your incomes (i.e. Old Age Security, Canada Pension Plan, etc.) and all of your expenses will give you an idea of the monthly excess or shortfall.         

It is at this stage that an advisor can be invaluable for mapping out and explaining the various options.  Many seniors are looking for income.  In years past, income was closely associated with fixed-income investments (i.e. bonds, GICs).  As interest rates have declined, so has the income level for seniors relying on traditional fixed-income options.  It is still possible to create a good income portfolio but this often involves looking beyond traditional fixed income, at least for a portion of the investments. 

An advisor should be able to map out the various types of investments that pay income.  With each type of investment your advisor can explain the tax characteristics of the payments, frequency of payments, and risks. 

Creating a diversified income flow often involves using a variety of investments.  An income investor could have GICs, corporate bonds, debentures, bond ETFs, preferred shares, blue chip common shares, etc.  Many forms of income are tax efficient, including both preferred and common stocks that generate dividend income.  Many preferred and common shares have dividend yields that are higher than GICs and investment grade bonds.

There is no low risk option that generates high income. I frequently explain to clients that you can enhance your potential return by taking a little risk; however, the element of risk still exists.  Knowing that risk also exists in fixed income, and that life expectancies are longer, many seniors have opted to adjust their asset mix to include other investment opportunities that generate income within their portfolio. 

Historically, a senior could take a very passive fixed-income approach in retirement.  Today, seniors have to be more involved in their investments.  It is important for seniors to work with a financial advisor to design a portfolio that matches their risk tolerance and investment objectives, such as income and capital preservation.

Research ETFs before you buy

Exchange Traded Funds (ETFs) have become one of the fastest-growing areas of the financial market.   “Index Shares” is another similar term and many advisors use these terms inter-changeably.  Investors can participate in a broad variety of investment opportunities using ETFs. 

The original ETFs differed from traditional actively managed mutual funds as these are passive products.  For example, an investor could purchase an ETF of a well-known index such as the S&P 500 which holds the largest 500 U.S. public issuers. 

As their popularity has grown, so has the number of ETFs being created.  Some companies are creating a hybrid product with relatively low fees and some active management.  The water is getting a little murkier as new features are being added to these new products, so I caution investors to understand before they buy.

One reason for the growth in ETFs is the relatively low cost and transparency of the fees.  Investors do not want to be burdened with the cost of high fees, especially if these are hidden or embedded.   The management fee for the S&P 500 is 0.14 per cent through iShares by BlackRock (TSX symbol: XUS), and 0.15 per cent through Vanguard (TSX symbol: VFV).  These are just two symbols that track this common Index.  Other ETF examples trade directly on US exchanges and some that are currency hedged.  You should have full understanding of the tax component, risks and features before purchasing.

The annual cost of an actively managed mutual fund is significantly more than an ETF.  Mutual funds have a Management Expense Ratio (MER) that is embedded.  New regulations and rules are coming soon that will require full disclosure of all fees.  Trading costs are in addition to the normally published MER.  A passive ETF would have very little trading.  Like all services, fees are really only an issue in the absence of value. If an actively managed mutual fund is consistently performing better than an ETF, then the MER and trading costs may be fully warranted.

Some advisors may not recommend ETFs for a few different reasons.  It could be that an advisor only has a mutual fund licence and they are not permitted to discuss or provide ETFs as an option.  Mutual funds can be sold on a no-load, front-end (initial service charge) or a back-end (deferred service charge) basis. We recommend that investors ask their advisor what the initial commissions are, the ongoing trailing commissions, and the cost to sell the mutual fund investment.  Understanding the total cost of choosing an investment option should be done prior to purchase.

ETFs are very much an option that can complement a fee-based account.  Both cost structures are low and provide complete transparency.  ETFs are listed, and trade, on exchanges similar to stocks.  For transactional accounts, there is a cost to purchase an ETF, and a cost to sell them.  For fee-based accounts, there are no transaction costs to purchase or sell an ETF, however, the market value of the amount purchased would be factored into calculating your fees.

When a new client transfers in investments traded on an exchange, it is always easy to make changes.  Investors who have purchased proprietary mutual funds or mutual funds purchased on a low load or deferred sales charge may have fewer options.  In most cases, proprietary funds cannot be transferred in-kind and a redemption charge may apply to transfer in cash.  For example, say Jack Jones has $846,000 in a basket of mutual funds in his corporate investment account.  Jack is paying 2.37 per cent (or $20,050) annually in MERs to own his mutual funds.  I mapped out a lower-cost option for Jack that would decrease his cost of investing, to one per cent ($8,460).  The approach to investing involves a fee-based account with a combination of direct holdings and ETFs.  Annually, Jack would save $11,590 and have full transparency and liquidity.

ETFs can be used strategically to obtain exposure to various types of asset classes, sectors, and geographies.   Although the cost is lower, they are not immune to declines when markets get shaky.  An advisor can design a portfolio of positions that are lower risk then the market.  This is tougher to achieve with off-the-shelf  ETFs. 

Although the traditional ETF is a passive approach, we still feel that an advisor can provide advice with respect to the active selection of the ETF, tax differences, hedging options and more.   To illustrate using bond/fixed income ETFs, an investor could choose amongst many different types depending on the current environment (i.e. interest rate outlook, current economic conditions). 

An advisor can provide guidance on whether to underweight or overweight government bonds or corporate bonds and provide guidance on whether you have a short term, long term, or laddered bond strategy.  Based on your risk tolerance, should you stick to investment grade bonds or seek out greater returns with high yield bonds.  An advisor can explain some of the more complex fixed income ETFs including those holding real return bonds, floating bonds, or emerging market bonds.   An advisor can provide recommendations with respect to actively switching between these passive ETFs.

 

On having enough financial resources through retirement

Balancing living for today and not running out of money in retirement is perhaps the greatest financial challenge most people face.  Even financially well-off people wonder if they have enough for retirement.

In past decades, people with limited resources have received assistance through government funded programs, including subsidized residential care and extended care.  There is a general concern about how the government will be able to continue funding assistance programs for seniors and whether they will be able to offer the same level of assistance in the future.  This is a real concern given the rising costs of these programs, especially given increasing number of seniors as the population ages.

A baby born today in British Columbia has a life expectancy of 81.7 years according to Statistics Canada.  If you’re 65 years old this year, StatsCan suggests that your life expectancy is 85.7 years.  Both of these life expectancy numbers are at the highest levels they have ever been.  Although recent studies have suggested that babies born today may actually have a shorter life expectancy than their parents as a result of health issues such as increased obesity and diabetes.    

With financial planning, assumptions are made with respect to rates of return, inflation, income tax and life expectancy.  The younger a person is, the more challenging it is to project these assumptions.  Rates of returns have fluctuated significantly for both fixed income and equity markets over the years.  Federal and provincial governments can make future modification to various programs such as benefit payments, income taxes or credits that will have a direct impact on your retirement income.   One of the assumptions to consider in retirement financial planning is your life expectancy.  The chart below shows the required savings for different life expectancies and demonstrates how your life expectancy can make a material difference.

In all scenarios, the assumptions are identical where the rate of return is four per cent, inflation is two per cent, and income tax is at 30 per cent.   For illustration purposes, we will assume an individual requires $50,000 annually after tax.  The following table gives you a financial view of the capital required in a RRIF account at age 65 with the following different life expectancies:

Life Expectancy           Savings Required @ Age 65

            75                                $522,439

            80                                 $745,470

            85                                 $959,956

            90                                  $1,166,227

            95                                  $1,364,592

            100                                $1,555,361

Another variable is the type of accounts in which investors have saved funds.  If you have funds in a non-registered account or a Tax Free Savings Account then the numbers are lower than the table above.  Having a combination of accounts (non-registered, TFSA, and RRIF) at retirement provides you the benefit of smoothing taxable income and cash flows.

Building up sufficient financial resources before you retire takes away the reliance on government funded programs and the concern of running out of money.  Financial security is achieved when you have enough resources to dictate the quality of care you receive as you grow older.  Often at times in financial plans we factor in the assumption that the principal residence could be sold to fund assisted living arrangements.  I’ve never prepared a financial plan with the assumption that the government will be paying for a client’s long term care. 

I also advise my clients to understand the issue of incapacity and how to manage this should it arise.  When planning for the most likely outcome, many people will become incapacitated (mentally or physically) for a period of time before they die.   In some cases the period of incapacity can extend for a significant length of time.

I encourage clients to take appropriate steps to deal with the financial cost of incapacity and think about how their finances would be managed if they became incapacitated. 

While they are still able, clients should ensure all legal documents (will, power of attorney, representation agreement) are up to date.  Part of this process involves reviewing the beneficiaries on all accounts to ensure consistency with your estate plan. Simplify finances by closing extra bank accounts and consolidating investment accounts.  All government benefits such as OAS and CPP as well as pensions (RRIF and RPP) should be deposited into one account, which makes it easier to budget for excess or short-falls.  Most expense payments should be automated. 

If you lose capacity or interest, it is easier for your power of attorney to review one bank statement for transactions.  In many cases, a meeting with a client and the client’s legal power of attorney is necessary to set up a “financial” power of attorney.  This power of attorney allows a person the ability to request funds to be transferred from your investment account to your bank account, if funds are running low.  Clients can set up managed accounts where a portfolio manager can act on your behalf on a discretionary basis.  Financial mail can also be sent to the power of attorney.  When bank and investment accounts are consolidated, your power of attorney can easily review and monitor the accounts through monthly statements or online access.

 

Kevin Greenard, CA FMA CFP CIM, is an Associate Portfolio Manager and Associate Director with The Greenard Group at ScotiaMcLeod in Victoria.  His column appears every second week in the Times Colonist.  Call 250-389-2138 or visit greenardgroup.com

 

 

Benefits to early conversion of RRSP to RRIF

The Registered Retirement Savings Plan (RRSP) is for “saving.”   This savings and tax deferral within an RRSP can continue until the age of 71.  In the year you turn 71, you have to either close your RRSP by either taking the money out, purchasing an annuity or transferring it to a Registered Retirement Income Fund (RRIF). 

From a taxation standpoint, it is rarely advised to de-register 100 per cent of your RRSP in one year and withdrawal the cash.  This would only be advised when an RRSP is very small or there is a shortened life expectancy or financial hardship.   Purchasing an annuity as an RRSP maturity option is a final decision that can not be reversed.  Upon your death, the annuity option often leaves nothing for your estate or beneficiaries.  

For many reasons, conversion of your RRSP to a RRIF is the most popular and flexible method.  Most of your savings will continue to be tax deferred with a minimum withdrawal amount being determined annually based on the previous December 31 value.  In the year a RRIF is set up, there is no minimum withdrawal amount.   All RRIF’s set up after 1992 are considered non-qualifying.  The following minimum RRIF withdrawal amounts are the non-qualifying annual percentage by age on December 31st: 

Age                 Per Cent        

72                    7.48    

73                    7.59

74                    7.71

75                    7.85

76                    7.99

77                    8.15

78                    8.33

79                    8.53

80                    8.75

81                    8.99

82                    9.27

84                    9.93

85                    10.33

86                    10.79

87                    11.33

88                    11.96

89                    12.71

90                    13.62

91                    14.73

92                    16.12

93                    17.92

94 or older      20.00

To illustrate how the above schedule works, we will use 71-year-old Barry Campbell who has saved $1million in his RRSP.  Barry is single and he chose to convert his RRSP to a RRIF account in the year he turned 71 and he will begin taking annual payments next year.  Barry has had years of complete deferral but this is coming to an end.  Based on the above minimum RRIF schedule, Barry will be required to withdraw $74,800 ($1 million x 7.48 per cent) and have this amount included in his taxable income.   Unfortunately, Barry doesn’t have a choice at age 71.  Based on Barry’s total income with the RRIF, he is projected to have half of his old age security clawed back (required repayment) based on his high income.  If Barry were to pass away, the majority of the RRIF would be taxed at 45.8 per cent.  Unfortunately, Canada Revenue Agency (CRA) would receive nearly half of Barry’s lifetime savings within his RRIF.   

We feel it is important for clients to understand the taxation of a RRIF in a most likely scenario of normal life expectancy and shortened life expectancy.   RRIF accounts for couples greatly reduce the taxation risk of shortened life expectancy by being able to name your spouse the beneficiary and avoid immediate taxation of the full account balance.  In 2007, CRA introduced pension-splitting, which provides taxation savings for most couples with eligible pension income. RRIF withdrawals at age 65 or higher are considered eligible. 

Beginning in 2009, CRA introduced the Tax Free Savings Account (TFSA) that provides tax savings for individuals and couples.  The savings is a result of all income (interest, dividends, and capital gains) generated within the TFSA not being taxed ever.  There is no taxation upon your death.  The amount that can be put into a TFSA is limited by a relatively small amount each year. People who are serious about saving for retirement often contribute to both an RRSP and TFSA.

Given the introduction of pension splitting and the TFSA, many people should be looking at converting their RRSP to a RRIF before the age of 71.  When we are helping clients with the optimal time to convert their RRSP, we look at their marital status, health/genetics, and other investments.  With other investments, we create two baskets (A and B) to analyse what we call the “bulge.”  A bulge is when you have too much concentration in either basket A or B.  Basket A is the total amount in your RRSP accounts.   Basket B would include bank account balances, non-registered investments, and your TFSA – none of which will attract tax on the underlying equity if used.  Basket A may also include your principal residence if the intention is that this will be sold and the capital used to fund retirement.  

We caution investors not to create a bulge – having too much in either basket means you may not have the right balance as you enter retirement.  Taking advantage of deferral opportunities over time often makes sense.  Having too much in basket A means you may have very little flexibility if an emergency arises and you need cash (new roof, vehicle).   If A / (A + B) is greater than 75 per cent (a bulge) then we would recommend you speak with an advisor to determine in you should convert your RRSP to a RRIF early.  Above, we noted Barry has $1 million in basket A.   Barry also has $250,000 in basket B.  With these numbers Barry has a bulge percentage of 80 per cent. 

A financial plan prepared while you’re working largely results in savings strategies to reach your retirement and other goals.  In retirement, a financial plan is prepared to create withdrawal strategies that are tax efficient and smooth out your income during your lifetime.  They can also be prepared in conjunction with estate planning.   

Kevin Greenard CA FMA CFP CIM is an Associate Portfolio Manager and Associate Director with The Greenard Group at ScotiaMcLeod in Victoria.  His column appears every second week in the TC.  Call 250-389-2138.

As tax time looms, it’s prudent to get your plan in place

This time of year you should be talking with your financial advisor about where to put your hard earned money.  Will you contribute to an RRSP or pay down debt?  Or should you do both by contributing to an RRSP and using the tax savings to pare debt?

Contributing to an RRSP should be done with a view of keeping the funds committed for a longer period of time and pulling them out at retirement, hopefully when you’re in a lower income tax bracket. This option is suitable for individuals who have stable income.  If it’s debt reduction, you always have the flexibility of taking out equity in your home later on if capital is needed. On the other hand, if you need capital and your only access to savings are from your RRSP you will have to make one of the most common RRSP mistakes – deregistering RRSPs before retirement and paying tax. In addition, you will not have the RRSP contribution room replenished.

Since 2009, financial options were further complicated with the introduction of the Tax Free Savings Account (TFSA). The main benefit of an RRSP is the deferral of income within the account until the funds are pulled out. Another is the tax savings in the period in which the contribution is first applied. The TFSA has the same first benefit of an RRSP, deferral of all income including interest, dividends and capital gains. TFSA contributions do not provide you a tax deduction; however, withdrawals are not taxed at all. Withdrawals can be replenished in the next calendar year. .

Business owners have the ability to have active small business income taxed at a lower rate. Most owners are encouraged to pull out only the income they need to live on. The rest of the income is left in the corporation. Income paid out of the corporation is either through dividends wages, or both. Should business owners still contribute to an RRSP or TFSA when income is already taxed at low rates?  Wages paid helps future CPP benefits and also creates RRSP deduction room.  Dividends paid can be tax efficient, but do not create RRSP room and have no benefit for CPP purposes.  Some organizations provide RRSP programs that involve matching and length of service programs that are linked to the member’s RRSP.

Singles have a higher likelihood of paying a large tax bill upon death. With couples, the chances that one lives to at least an average life expectancy are far greater. Couples can also income split where the higher income spouse can contribute to a spousal RRSP.

If you have a good company Registered Pension Plan (RPP), you may not have a great a need to have an RRSP. If a person had debt and a good RPP then the decision to pay down debt is a little easier than someone that doesn’t have an RPP at all. Individuals who have no other pensions (not counting CPP and OAS) really need to consider the RRSP and how they will fund retirement.

Income levels below $37,606 in BC are already in the lowest income tax bracket. Contributing $5,000 to an RRSP while in the lowest bracket would result in tax savings of approximately $1,003 or 20.06 per cent.  Income over $150,000 is taxed at 45.8 per cent and this same contribution would save $2,290.   I would encourage the lower income individual to put the funds into a Tax Free Savings Account or pay down debt depending on other factors. If the lower-income individual’s income increased substantially, then the option to pull the funds out of the TFSA and contribute them to an RRSP always exists.

In order for your advisor to provide guidance about the right mix between TFSA, RRSP, or paying down debt, they require current information.  In some cases, your advisor should be speaking with your accountant to make sure everyone is on the same page.  Every situation is unique and your strategy may also change over time.  Preparing a draft income tax return in late January or early February helps your advisor guide you on making the right decisions.

The submitting of your completed tax return should be done only when you are reasonably comfortable you have all income tax slips and information. Some investment slips, such as T3s, may not be mailed until the end of March. We recommend most of our clients do not file their income tax return until the end of the first week of April.  By providing projected tax information to your advisor in January or early February you have time to determine if an RRSP should be part of the savings strategy. If it is not, the discussion can lead to whether you should pay down your mortgage or contribute to your Tax Free Savings Account.  

Most mortgages allow you the ability to pay down a set lump sum amount (such as 10 or 20 per cent) on an annual basis without penalty.  Every January you are given additional Tax Free Savings Account room. 

Liquidity in investments

Investments that can be bought and sold easily are considered to be liquid. Investments that are difficult to buy or sell are considered illiquid. Liquidity is one of many important objectives of investing. We can actually look at liquidity in several different ways, and for purposes of this article I’ve broken it down to four general discussion items, as follows: Basic Rules of Settlement, Liquid for a Cost, Exceptions to Liquidity, and Ratio of Liquid to Illiquid.

Basic Rules of Settlement

When buying and selling different investments, there are specific rules with respect to transaction dates and liquidity. Two dates are often used to describe transactions, trade date and settlement date. Trade date is fairly straight forward to understand. It is normally the day your purchase or sell is first executed. If you spoke to an advisor after cut off times (i.e. market hours) and your advisor entered the order for the next market day then trade date would be the next market day. Settlement is a little more difficult to understand and changes with different investments. The following is a chart with the most common investments and the respective settlement dates:

Common Investments

Settlement Date = Trade Date + (below)

Money Market Mutual Funds

1 business day

High Interest Savings Accounts

1 business day

Short Term Bonds (3 years or less)

2 business days

Long Term Bonds (3 years plus)

3 business days

Mutual Funds

3 business days

Canadian and US Equities

3 business days

European and Foreign Equities

Depends on market

To illustrate trade date and settlement date we will use a typical week with no public holidays. Michelle purchases a stock named ABC Company on Monday – this is the trade date. Settlement as per the above schedule for equities is the trade date plus three business days – settlement is on Thursday. What this means is that Michelle does not have to deposit money into her investment account until Thursday, even though the investment was purchased on Monday. If Michelle already had money in a high interest savings account then her advisor could sell a portion of this investment on Wednesday to cover the purchase. The opposite happens when an investment is sold. Let’s assume that a few months go by and Michelle needs some money and sells ABC Company on Monday – this is the trade date. Although we did the trade on Monday, the settlement date is Thursday. We would not be able to transfer funds to Michelle until the settlement on Thursday. We explain settlement to new clients to ensure they give us a few days notice if they require funds.

Liquid for a Cost

At any time you should have the right to make a change in your investments without it costing you a fortune. Having flexibility with investments ensures you never feel like you are backed into a corner with no options. We recommend asking the liquidity question prior to making any investment decisions – what will it cost me tomorrow if I need to sell. Everyone should know the total cost to liquidate an entire portfolio. When I have sat down with people wanting a second opinion the first thing I look at is the types of investments they have and what it would cost to make any necessary changes. I will use Wendy who came in for a second opinion as an example. Wendy was holding a basket of proprietary mutual funds that were originally sold to her more than two years ago on a deferred sales charge (DSC) basis. I explained that with proprietary mutual funds they can not be transferred in-kind (as is). Her only option was to sell the mutual funds, and transfer the net cash after redemption charges, if she wanted to make a change with her investments. In explaining DSC mutual funds to Wendy, she was shocked to know it would cost her four per cent (or $23,200) of her $580,000 investment account to make a change even though she has owned these investments for more than two years. Immediately Wendy felt she was backed into a corner. I explained to Wendy that if she had sold these mutual funds soon after she purchased them two years ago then the cost would have been $37,700. Although Wendy had liquidity, it was liquidity for a cost – she had no idea. In my opinion, every investor should avoid being backed into a corner with excessive liquidity costs.

Exceptions to Liquidity

Not every investment will be easily converted to cash. Your principal residence is one investment that is not easily converted to cash. Many assets that people buy either have restrictions on when they can be sold or take significantly longer than the settlement dates for common investments noted above. Examples of investments that are not easily liquidated include: infrastructure assets, private real estate investments, antiques, art work, private companies, hedge funds, flow-through investments, venture capital funds, etc.. Some investments have in the fine print that they reserve the right to suspend redemptions under certain circumstances. It can be very frustrating for people who have invested in illiquid investments and would like their money back. Prior to purchasing any investment you should determine if it is liquid, illiquid, or has the possibility of becoming illiquid. If it is illiquid you should be prepared to hold it until key dates are reached or a liquidity event occurs.

Ratio of Liquid to Illiquid

A good exercise for all individuals is to list all of your investments and categorize them in the liquid or illiquid category. In my opinion, everyone should have some liquid investments, including cash as an emergency reserve, or investments to either obtain income, growth, or a combination of both. There is no set rule on what ratio of liquid to illiquid investments people should have. As a general guideline, younger individuals may have more illiquid investments, especially if they have real estate with debt or the higher risk tolerance to invest in illiquid investments. Another general guideline is that as people age, or if they have a lower risk tolerance, the ratio may favour liquid investments.

Timing stock markets is always a challenge

At any point in time the stock market can either go up, stay at current levels, or decline. However, over time the stock market has an upward bias. During the last twenty years the TSX/S&P Composite Index has increased annually 8.19 per cent in spite of volatility during this period. When the stock market takes a sharp downward correction, the natural response from investors is to try to anticipate the decline and sell off before this happens. It sounds easy when you’re looking in the rear view mirror. Timing when you’re in or out of the markets is in essence basing your investment strategy on a speculative approach rather than a disciplined investing approach that incorporates a long term vision and goal. Short term emotional thinking can cloud long term investment decisions.

The best way to illustrate the challenges of trying to time the stock market is by looking at an investor who is currently fully invested. Mr. Wilson has $1,000,000 invested and is currently earning $40,000 in annual income from dividends and interest. In addition to this income, Mr. Wilson’s investments fluctuate in value based on the markets which create either capital gains or losses.

Mr. Wilson decided that he wanted to be a market timer. By market timer, I mean that he felt he could predict the direction of the stock market and would sell his investments if he anticipated a decline in the markets. If Mr. Wilson sells off his investments and converts his portfolio to 100 per cent cash, then his income will drop to $12,500 per year, assuming that savings accounts are earning 1.25 per cent. The downside to savings accounts is that interest income is fully taxable each year. Mr. Wilson currently has the majority of his investments earning tax efficient dividend income with some tax deferred growth. As a result of the difference in taxation between interest income and dividend income, the impact on income would be even greater than 2.75 per cent (4.00 – 1.25). For purposes of this article, we have assumed that both interest income and dividend income are equal.

Mr. Wilson should also factor in that if all of his investments are sold then he would have to report all the realized gains on his investments and lose the deferral benefits that exist with non-registered equity investments. If you have stock that has increased in value, you do not have to pay tax on the capital gain until it is sold. If Mr. Wilson has a stock that has declined in value and he realizes a loss then he has to use caution when timing transactions. He must wait at least 30 days before repurchasing a stock sold at a loss or risk violating the superficial loss rules and having the original loss declined.

From an income standpoint, Mr. Wilson will immediately see his income drop $27,500 a year ($40,000 – $12,500). The potential tax liability, superficial loss rules and loss of income are the easy components to quantify for Mr. Wilson. Has Mr. Wilson made the right choice to liquidate? If the markets increase then Mr. Wilson clearly made a mistake. If the markets remain flat then Mr. Wilson still made a mistake as his income will drop $27,500 a year.

If the stock market goes down it’s not necessarily a given that Mr. Wilson will benefit from having liquidated his account. If Mr. Wilson makes a correct prediction that the stock market declines then for him to benefit he has to also make another correct timing decision to buy back into the market at lower levels to potentially be better off. If the markets decline and Mr. Wilson does not have the insight to buy back in (before it rises back to the level that Mr Wilson originally sold at) then he would still be worse off. In essence Mr. Wilson has to make two correct timing decisions: (1) selling before the markets decline, and (2) buying back before they rise.

Mr. Wilson should also factor in the timing in which he feels his predictions for the market will unfold. To illustrate this component we will assume no transaction costs and no tax impact to the trades for simplification purposes. The difference between the current income Mr. Wilson is earning of 4.0 per cent and the new income of 1.25 per cent if he converts everything to cash is 2.75 per cent. Depending on how long Mr. Wilson is out of the market impacts how much the stock market would have to decline to make the strategy of going to cash successful. Let’s assume that Mr. Wilson waits six months, one year, two years, and three years before buying back into the stock market. If every year Mr. Wilson is losing 2.75 per cent in income then the longer he waits the greater the stock market has to decline. At the six month point the markets would have to decline 1.38 per cent (2.75 x .5) or greater, at the one year point the markets would have to decline 2.75 per cent (2.75 x 1) or greater, at the two year point the markets would have to decline 5.5 per cent (2.75 x 2) or greater, and at the three year point the markets would have to decline 8.25 per cent (2.75 x 3) or greater.

Making two right short term timing decisions against a stock market that has a long term upward bias is not as easy as it may seem.

Switch trade strategies

In the last column I talked about model portfolios and how many advisors establish a uniform basket of stocks for their clients. Most advisors have two sets of lists for their model portfolios: one that has the stocks they are considering buying and another that has the stocks they are considering selling. One trading tool that advisors use in developing and keeping their model portfolio basket of stocks up to date is switch trades. A switch trade occurs when a position is simultaneously sold from a model portfolio and another position is bought.

Mr. Jones is retiring and now requires income from his portfolio. Mr. Jones came to us for a second opinion. Currently he holds $500,000 in mutual funds that are not generating any income, while also paying the management expense ratio that costs $12,000 annually. We suggested he sell these mutual funds and switch into a basket of direct holdings containing dividend paying blue chip equities that would pay him a minimum of $20,000 in dividends annually. This would increase his income substantially. Moreover, he would save $7,000 annually since direct equity investments through a fee-based account would have lower investment costs than mutual funds. His investment costs for the blue chip equities would bring his cost of investing down to $5,000 annually.

When an individual is fully invested, such as Mr. Jones, switch trades are effectively the only way someone can purchase securities. Initially, Mr. Jones will be executing switch trades on a macro level as he is completely remodeling his portfolio from entirely mutual funds to all direct holdings. Once his portfolio contains direct holdings, switch trades will be executed on a micro level. Essentially, you sell the weakest name to purchase what you feel is a stronger name. These switch trades can be done for many different reasons, some of which will be explained below.

Changing Objectives

As your investment objectives change, certain securities may no longer be appropriate for your current situation. Switch trades can be used in these circumstances to better align the portfolio with your needs, investment objectives and risk tolerance. For instance, a switch order could be placed to liquidate a higher risk holding for a lower risk holding and vice versa.

Changing Yield

To increase the overall yield of the portfolio, you may wish to substitute one position for another with a higher yield. As stated above, if you are fully invested, you may not have funds available or the liquidity necessary to act on a trade quickly which could increase your portfolio’s yield. Therefore, by executing a switch trade, you will be able to purchase a new holding and increase the income. On the other hand, if you have a net capital loss carry forward, or if you want to defer growth, a strategy could be implemented to focus on growth stocks with little dividends. Investors can benefit from switch trading both by changing to a lower or higher yield, depending on their unique situation.

For example, Mr. Jones is trying to increase his yield to provide retirement income. He currently holds a growth stock with a yield of 1.2 per cent; however, he is looking for a higher yield and is interested in switch trading his growth stock for a value stock that pays 4.6 per cent. If Mr. Jones holds a position of $20,000 with the growth stock’s yield of 1.2 per cent, he will make $240 in dividend income. If Mr. Jones switched to the value stock with a yield of 4.6 per cent, his annual dividend income would increase to $920 (a $680 increase) on that one holding of $20,000.

Sector Rotation

Due to market variations, each of the different sectors may be either underperforming or outperforming others during any given period. Switch trades can be useful in these instances for re-balancing a portfolio to overweight or underweight a different sector. By using a switch trade, investors are able to rotate between sectors with relative ease, allowing them to overweight a sector that is expected to outperform and underweight a sector expected to underperform.

For example, the value of Mr. Jones’s stocks of company ABC have appreciated nicely; however, he believes their sector will soon decline and he is now looking to sell those stocks. With the proceeds, Mr. Jones is looking to invest in stocks of company DEF, which is in a sector that he believes will outperform in the future. A switch trade can be done to execute this order. Mr. Jones holds 200 shares of ABC, currently selling at $50 a share. As ABC is sold, the switch trade simultaneously buys DEF with the proceeds. Since DEF is currently selling at $25 a share, Mr. Jones is able to buy 400 shares. As a result of this switch trade, Mr. Jones is now overweight in a sector expected to outperform, and has minimized his holdings in a sector expected to underperform.

Asset Mix Rebalancing

Your asset mix is not static; rather, it is always fluctuating depending on the current state of the markets. With time, it’s not uncommon for an investor’s portfolio to stray from its prescribed ranges due to market movements. Switch trades can be used to rebalance your portfolio, keeping it consistent with your initial asset mix weightings and risk tolerance. For example, over time Mr. Jones’s portfolio has become unbalanced, and he is now overweight in equities and requires more fixed income. To solve this, a switch trade can be executed selling equities and buying fixed income. Alternatively, if Mr. Jones was underweight equities, he would sell fixed income and buy equities through a switch trade.

Tax Planning

For tax planning purposes, switch trades are ideal for ensuring you are minimizing the amount of tax you pay. As an illustration Mr. Jones has experienced a capital loss in a particular stock in the energy sector; however, he wishes to keep the same weighting of energy in his portfolio. An option for Mr. Jones in this situation is to place a switch order. By selling the energy stock he currently owns and simultaneously buying another similar energy stock, Mr. Jones is able to use the capital loss to reduce his tax payable for that year while still maintaining the same weighting in that sector. By keeping the same weighting in a sector, an investor will benefit from any sector recovery.

Reflect on investments during tax time

As a Chartered Accountant I’ve always felt that it is a good thing if a person owes taxes – it means that you had income. Investment income is generated from taxable capital gains, dividends, and interest income. When I worked directly in public practice as a Chartered Accountant we had the ability to see the investment returns of all tax clients. One thing for sure is that the returns would vary considerably based on how savings were invested and with who they were invested with.

From time to time, we would see an individual who had significant savings but was not generating sufficient income from those savings. To illustrate we use Betty Brown who received a $500,000 life insurance payment when her husband passed away two years ago. In our first meeting we reviewed Betty’s prior year tax return and current investments. We noticed a T5 (income tax slip for investment income) in the amount of $4,750 for interest income and some high cost mutual funds that were under performing. This translated to a return of less than one per cent before tax. The T5 that she did receive was fully taxable interest income from her GICs. In talking to Betty we discussed that our “income” goal for clients is four percent. In her case, that would be $20,000 versus the $4,750 she is currently receiving. We also notice that Betty was generating some rental income from an investment property. We scheduled a second meeting to show her our plan.

At the start of our second meeting we explained to Betty that not all income is created equally. Interest income is the worst type of investment income as it is fully taxable in the year it is earned. We explained how some equity investments generate tax efficient dividend income that qualifies for the dividend tax credit. We also outlined how she could take advantage of the deferral rule on equities. The deferral rule essentially means that Betty would not be taxed on any gains until she decides to sell the investments. Betty understood this quickly as we compared this to her rental income. Years ago she had bought an additional investment property to generate rental income. Annually she has to declare the rental income. The value of the property has increased over the years but she has not had to report this. When she sells the property she will have to pay tax on approximately one half of the profits from the property value increase. This is an example of both deferral and tax efficient taxable capital gains on the eventual sale. The rental income is not tax efficient – it is like interest income.

We also talked about how equities pay dividend income which is tax efficient. Dividend income is significantly better than both interest income and rental income. Betty was excited about both the increased income and the tax efficient approach of buying direct common and preferred shares. Betty mentioned that she was still nervous about investing in the stock market. I explained to Betty that she had approximately $250,000 already in the stock market through her higher cost and under performing mutual funds. Betty was also unaware that she was paying $6,750 which was embedded in her higher cost mutual funds ($6,750 was calculated by multiplying the $250,000 in mutual funds by the average management expense ratio of 2.7 per cent).

In the discussion with Betty we mapped out a plan to largely replace the GICs with ten preferred shares and to replace the mutual funds with thirty large dividend paying common shares. We recommended opening up a fee-based managed account that would enable us to set up the accounts with no transaction and commission costs. Betty’s cost of investing would drop immediately and she could also begin deducting the fees she pays as investment council fees on her tax return. The plan that we mapped out would lower Betty’s fees, convert the cost of investing so it is fully tax deductible, increase her income, improve the transparency, and ensure she has maximum flexibility and liquidity.

We outlined the specific investments Betty would receive and how the tax efficient income is generated. Betty really liked the expected income report and how we could automate transferring all of the dividend income directly from her investment account to her bank account on a monthly basis. Betty even thought that this would allow her to stop working part time.

Our biggest concern with new clients investing in direct equities for the first time is to ensure they understand that not every stock will go up. In outlining the above with Betty we explained how she will see more volatility in the 30 common shares versus the mutual fund approach. It is generally a success if 25 stocks go up in value and only five go down. The main focus should always be on the total account rising in value from net growth in the share prices plus generating approximately four per cent from income. The growth will be variable, and possibly negative in some years. Over a reasonable time, Betty should experience more positive years then negative while experiencing significantly higher after tax investment income.

This article is intended as a general source of information and should not be considered as personal investment, tax or pension advice. We are not tax advisors and we recommend that individuals consult with their professional tax advisor before taking any action based upon the information found in this publication.