How to generate a tax-efficient income

In the early 1980s, financial planners often had a general rule of thumb that the amount you had in low risk investments, such as bonds and guaranteed investment certificates (GICs), should equal your age.

For example, John Smith who had retired in 1981 at age 60, may have been advised to have 60 per cent in fixed income at that time.  Let’s also assume that John Smith had $500,000 when he retired.  In 1981 interest rates on GICs and other low risk investments, including annuities, would often yield 15 per cent or more.  If John had put all his money in fixed income at 15 per cent then the annual income would have $75,000 a year.

John had a son named Paul who is 65 today.  Paul is struggling with the fact that guaranteed investments today do not have the same yields that his father had.  Paul has $1 million in the bank but is looking at yields of just over one per cent to keep the money in the bank or up to three per cent if he commits to a five year term.   A return of between $10,000 and $30,000 is what Paul is looking at today if he wants a guarantee on his investments.

Many investors like term deposits and GIC for the simplicity and safety.  Unfortunately, investors pay little attention to the risk that their low interest earning investments may not preserve purchasing power over time. Interest rates on GICs are currently at low levels and when one considers the impact of taxes and inflation on their investments; their real rates of returns (return after accounting for inflation) can be negligible or potentially negative.

Let’s illustrate using Paul above who has $1,000,000 in non-registered funds.  One option he has is to hold $200,000 in five different GICs ranging from one year to five years (called laddering). We will assume that the basket of GICs have an average yield of 2.5 per cent.  We will also assume that Paul has a marginal tax rate of 30 per cent.  We will assume inflation is at 2.3 per cent.

GIC Income $1,000,000 x 2.5 Per Cent = $25,000

Taxes at 30 Per Cent                               =   (7,500)

Net Return                                               =  $ 17,500

A net return of $17,500, or 1.75 per cent, is what is ending up in Paul’s pocket.  With inflation greater than 1.75 per cent then the “real return” will be negative.  In other words the amount of money in Paul’s pocket will buy less as time goes on.  Investors with long-term objectives need to understand that the safety of GICs can actually erode the real purchasing power of their investments. In many cases, investors requiring income to provide for their day-to-day expenditures will be forced to encroach on capital as the real returns will be insufficient to meet their needs.

The Bank of Canada website has an excellent calculator for investors who want to computer their own numbers.  http://www.bankofcanada.ca/rates/related/investment-calculator/

Most economists are expecting interest rates to remain low for a long time.  The challenge Paul faces today is likely to extend throughout his early retirement.  Paul approached us to talk about an alternative to the net return of 1.75 per cent – this is before inflation.

The first thing we reviewed with Paul is that there is a cost to requiring 100 per cent certainty in this environment.  In talking to Paul about alternatives today we suggested that he consider diversifying his investments to include various types of investments including GICs, preferred shares, corporate bonds, convertible debentures, dividend paying common shares.

In mapping out some ideas for Paul we highlighted that preferred and common shares pay dividend income that is tax efficient.  We did some calculations to see what ends up in Paul’s pocket, after tax, is nearly double what the interest income would earn.  More importantly is that he is likely to earn more than the rate of inflation.

We spent a fair bit of time talking about inflation and what types of investments will protect him from this risk throughout his retirement.  Dividend paying common shares should keep better pace with inflation then low yielding interest bearing investments.  The dividend paying common share approach looks even better when you look at the after tax component noted above.

The challenge with the common share approach is dealing with the volatility of the stock market.   We spent a significant amount of time talking about his retirement.  We used a life expectancy of age 90, meaning 25 years in retirement.   During this period, Paul would expect to see various market cycles.  Rallies and corrections will occur during the bear and bull markets over the next 25 years.  The key point to focus on is income flow and longer term returns on the portion allocated to equities.

Despite the low interest rates today we still recommend that Paul have some fixed income.  This is the capital preservation side of his account that also generates income and protects his capital from a significant correction.  If rates rise in the future this will likely be the result of the economy moving in the right direction.  Assuming interest rates and equities rise in the early part of Paul’s retirement then he could begin reducing his equity exposure and gradually move the proceeds into fixed income.

Keys to tax-efficient investment portfolio

With tax season upon us, it’s important to revisit how tax efficient your investment portfolio is.  Fee-based accounts may provide tax benefits for investors who have non-registered investments or simply want to tax shelter more within their registered accounts.

On Schedule 4 of your income tax return you are able to enter items such as interest expense, safety deposit box charges, and investment counsel fees (relating to non-registered accounts).  The total of these are then carried forward to Line 221 (Carrying Charges and Interest Expense) and can be deducted on your income tax return.

Designation titles for financial professionals are changing.  In years past, stock broker and investment advisor were accurate descriptions as the services provided primarily related to picking investments.  Today, many financial professionals are realizing that clients are requiring a much more comprehensive type of service, and titles today – such as wealth advisors – are beginning to reflect this.  It is the complete package of services today that would be referred to as investment counsel fees.

We recommend everyone who has non-registered accounts to read Canada Revenue Agency’s (CRA) interpretation bulletin (IT-238R2) on this topic.  This bulletin is available online at www.cra-arc.gc.ca or by requesting a copy to be sent by mail 1-800-959-2221. After you have read this bulletin, and looked at your current accounts, you should check with your accountant to see if you are deducting100 per cent of the cost of investing in your non-registered account.

The best way to understand the benefits of a fee-based account is to compare it to a traditional transactional account.  We will use an investor named John who is in the process of setting up a non-registered account after he received an inheritance.

John already has an RRSP account where he holds a laddered fixed income portfolio.  Based on our review a transactional account is the most suitable type of account for John’s RRSP.  Only a couple of trades a year are required to reinvest maturing bonds within his RRSP.

John is interested in buying some individual equities and is unfamiliar with the costs associated with the initial purchases.  We explained to John that some investors open transactional accounts, and others open fee-based accounts.  The term “commission” is often associated with transactional accounts.

For every trade within a transactional account, an advisor would charge a commission.   The amount some advisors charge for smaller transactions may be around two per cent.  As the dollar amount of the transaction increases, the percentage may decline.  Most fee-based accounts are not charged a commission for trading activity.  The fee is based on the market value of the investments within the account.  Some advisors charge a lower fee as the market value increases.  John has approximately $500,000 and we will assume his fee is one per cent for the illustration below.

Assumptions:

  • John has $7,650 and would like to buy Royal Bank
  • John buys Royal Bank at $42.86 on January 1
  • John sells Royal Bank at $50.00 on December 20
  • John is in the 30 per cent marginal tax bracket.

Transactional Account

Factoring in commission, John is able to purchase 175 shares of Royal Bank.  The buy confirmation slip for Royal Bank would have a total purchase price of $7,500 plus a commission of $150 (two per cent x $7,500).   The total adjusted cost base is $7,650.  When John sells the shares on December 20 the proceeds are $8,750 less a commission of $175 equaling $8,575.   For tax purposes John would report a capital gain of $925 ($8,575 – $7,650).  The taxable portion is one half of this, or $463.  Assuming 30 per cent marginal tax rate, CRA’s share is $139.  Most importantly, what did John make?  John made $786 after taxes and commissions (plus dividends on Royal Bank).

Fee-Based Account

Commissions are not a factor when making purchases in a fee-based account.  We do have to factor in the fee that is paid to the advisor based on the market value of the investment.

One difference you will see right away is that John is able to invest the entire $7,650 into Royal Bank as there is no commissions.  John is able to buy 178 shares (rather than 175 shares in the transactional account) and still has $21 left over.

The buy confirmation slip for Royal Bank would have a total purchase price of $7,629 and this would also equal the adjusted cost base.

When John sells the shares on December 20 the proceeds would equal $8,900.  For tax purposes John would report a capital gain of $1,271 ($8,900-$7,629).  The taxable portion is one half of this, or $636.

Assuming 30 per cent marginal rate, the estimated tax on this amount is $191.   We estimate John would pay $83 in fees to the advisor relating to the market value of the amount invested.

This fee can be claimed on Schedule 4 and will result in a deduction and tax savings of $25 ($83 x 30 per cent).   CRA’s total share of this transaction is estimated at $166 ($191 – $25).

What did John make with the fee-based account?  John still had the residual cash of $21 not invested at the beginning plus the proceeds from the investment.  If we estimate the net amount owed to CRA ($166) and the fees paid to the advisor ($83), John made $1,022 after taxes (plus dividends on Royal Bank).

Let’s compare the above two options.  John made $786 in the transactional account versus $1,022 in the fee-based account.  John was further ahead by $236 for this one transaction.  If we assumed John had 30 companies in his portfolio with the same situation, annually he would be further ahead by approximately $7,080 with the fee based account.

The above highlights the tax savings of a fee based account.  The main reason for the difference is that the transaction commissions are higher and they are built into the adjusted cost and proceeds.  This effectively means that only one half of the commissions you pay will ultimately be able to potentially be deductible.

Other factors that influence John’s decision are:  type of investment account, level of trading activity, and the types of investments purchased are all key components.  If a person has net capital losses of other years then you should look even harder at the benefits of fee-based accounts.

If every purchase and sell you make in your account excludes commission charges then it increases your chance of having capital gains and being able to utilize both the tax deduction and loss carry forward room.  Another component to factor in is that fees are deducted in the year paid and you do not have to sell your investments.

 

Structuring your investments to reduce tax

Most investments can be classified as either debt or equity and both have their pros and cons.  We encourage most investors to have a balanced approach, meaning a mixture of both debt and equity investments.

With debt investments you are essentially lending your money to a corporation, municipality, province, or government.  There are many different names for debt investments, and the broad category is often referred to as fixed income.   The types of investments that fall into this category are bonds, GICs and term deposits.  Debt investments produce primarily interest income but can produce a capital gain (loss) if traded.

Pros of debt investments are that income is generally more certain, they reduce volatility, and provide capital preservation.

Cons of debt investments are that income is fully taxable in a non-registered account, they do not adequately protect you from inflation, and rates are currently very low.

With equity investments, you are purchasing a class of shares of a company.  The two main types are common shares and preferred shares.  Three differences between common and preferred shares deal with how they rank in the event of a company’s failure, their right to dividends (if any), and exposure to the success (or lack their of) of the company.  Equity investments may produce dividend income and/or capital gains (loss).

Pros of equity investments are that growth can be deferred if not sold, dividends are taxed more favourably than interest income, returns have the potential to be higher than debt investments, and protection against inflation.

Cons of equity investments are the volatility in the stock market, and the risk of losing capital.

As an investor it is always important to factor in the tax consequences of your investments.  After all, it is the amount that ends up in your pocket that counts, and not the gross income received.  The following illustrates the tax consequences of a top tax bracket individual (43.7 per cent marginal tax rate) who resides in British Columbia, and receives $1,000 through interest income, dividend income, and capital gains in a taxable account.

Description Amount Taxable Portion Tax Tax Credits  
Interest Income $1,000 $1,000 $(437) N/A $563
Dividend Income $1,000 $1,450 $(634) $350 $716
Capital Gains $1,000 $ 500 $(219) N/A $781

The above table becomes relevant as soon as you hold investments outside of a registered account, such as a cash, margin or corporate account.  When you have non-registered investments, you should structure your portfolio in a manner that creates the most tax efficiency.

One example of this is to hold debt investments within an RRSP as all interest income would be tax sheltered.  Your equity investments should be held in your non-registered account to take advantage of the taxation of dividend income, tax deferred growth on investments not sold, and eventual capital gain (loss) treatment when sold.

Value oriented investors are well aware of the positive effects dividends have had on their total returns over time.  A company’s board of directors may decide to pay a dividend to one or more of their class of shares.  They then select a date – referred to as the record date – to determine which shareholders are eligible to receive the dividend.

Dividends are usually paid quarterly and are more common among mature businesses that do not require all of their profits to fund future growth.  Growth oriented companies are less likely to pay dividends as they retain their capital to fund internal growth and in some cases make acquisitions.

Dividends are normally stated as a monetary amount per share.   If the company pays this quarterly, then the total dividends for the year are $2.00.  If the share price is currently at $80, then the yield is 2.5 per cent (2/80).  If the price of the share increases to $100, then the yield drops to 2 per cent (2/100).   If the price of the share decreases to $60, then the yield increases to 3.3 per cent (2/60).

The dividend gross-up and tax credit often confuses investors who are trying to do their income tax return for the first time.   The common question is: “if I received $100 in dividends, why am I taxed as if I received $145?”

This is called the dividend gross up and this is the amount you are first taxed on.  The highest marginal tax rate (combined provincial and federal) in British Columbia is 43.7 per cent.  Lower down on your tax return you have the dividend tax credit.

The most important component to note is that “credits” are better than deductions.  A credit is generally a dollar for dollar reduction from taxes payable.

One of the most underused tax strategies in Canada is the fact that gains on equity investments are not taxed until they are sold.  This tax friendly rule encourages people to make equity investments for the long term.   A part of the plan that we help set up for clients is to purchase select equities in a non-registered account and hold them for the longer term to take advantage of this rule.

From a tax standpoint, equity investments are superior.  So why not have 100 per cent equities?

From a risk standpoint, it is important to have balance.  In our opinion, stock market risk is greater than interest rate and inflation risk.

The key to any portfolio, is managing your own risk and comfort level.  Your risk tolerance, time horizon, need for cash flow, and current capital levels all need to be considered prior to determining a suitable mix between debt and equity investments.

Primer on foreign property

In 1996, legislation was passed requiring Canadian residents to disclose foreign property.  The threshold at that time was $100,000 Canadian, and the Canada Revenue Agency T1135 form was called Information Return Relating to Foreign Property.

There was plenty of discussion regarding the motives behind this new disclosure.  Some countries levy a capital tax based on net worth.  Others  have an estate tax.  The gathering of this information would certainly be useful if Canada one day ventured down this unpopular path.

Fourteen years later, we still have the same $100,000 threshold.  As you can imagine with the threshold staying constant, but prices rising over this period, more people today have to complete the T1135 form, now called Foreign Income Verification Statement.

Over the past couple of years, many Canadians have purchased (or have considered purchasing) US and foreign property.  We also have many people acquiring property in Canada and residing here who are citizens of other countries.

If you were a deemed resident of Canada in 2010, you have to answer the following question on your tax return:  Did you own or hold foreign property at any time in 2010 with a total cost of more than CAN $100,000?  If you do own foreign property of more than $100,000 then you are required to complete the Foreign Income Verification Statement (form T1135).

The types of foreign property are laid out into six categories:

  • Funds held outside Canada
  • Shares of non-resident corporations, other than foreign affiliates
  • Indebtedness owed by non-residents
  • Interests in non-resident trusts
  • Real property outside Canada
  • Other property outside Canada.

The form provides some further guidance on the property that is specified foreign property.  It also provides guidance on what is not considered foreign property including property in your RRSP, registered retirement income fund (RRIF) or registered pension plan (RPP); mutual funds registered in Canada that contain foreign investments; property you used or held exclusively in the course of carrying on your active business; or your personal-use property.

The above question and form (if applicable) is a regulatory requirement based on historical information or events that have already occurred.  Information is being shared between countries, and computer systems enable data to be audited more efficiently.  We recommend completing this form with help from a professional accountant who has appropriate tax knowledge.  Tax and financial planning today is more complicated, especially for clients who explore opportunities outside of Canada.

To help people with foreign property and income questions we gather as much information as possible.  This discussion begins with obtaining your accountants name and contact information.  Depending on the level of complexity, we would have an initial discussion with your accountant to obtain an understanding of your current tax situation.

Other information we gather are:  citizenship, residency, asset listing (including foreign property), and types of income (including foreign sources, such as pensions).  There are many US and foreign citizens who reside in Canada.  Tax and investment planning for these individuals are more complicated than Canadian born citizens who reside in Canada.

This is a difficult topic to discuss in a single column.  However, we have summarized our top ten items that we feel are important for people to discuss with their financial advisor and tax accountant :

  • Foreign House/Condo Purchase – If you have purchased real property in the US or foreign country is the property for your personal use or will it generate income?
  • US and Foreign Shares – If you have added shares of a US or foreign corporation to your portfolio, discuss the above reporting requirements and current/future tax consequences with accountant.
  • US and Foreign accounts Bonds – If you have added US or foreign government, state, municipal or corporate bonds, reporting requirements and tax consequences.
  • US and Foreign Bank Accounts – Factor into holdings and whether the T1135 disclosure is necessary.
  • UK Pensions – British expatriates are able to move pension benefits to Canada.  Speak with your financial advisor and accountant to discuss options.
  • Non-US Mutual Funds – American citizens residing in Canada should understand the changes to US tax for these investments.  Canadian mutual funds are now classified as a corporation rather than a trust.
  • Income Trusts and Pooled Funds – US citizens residing in Canada should understand the changes to US tax for these.
  • Registered Education Savings Plan – This type of account is classified as a foreign trust in the US (required IRA forms 3520 and 3520A) and we recommend that you discuss the reporting requirements and tax consequences with your accountant.
  • Tax Free Savings Accounts – This type of account is classified as a foreign trust in the US (required IRA forms 3520 and 3520A) and we recommend that you discuss the reporting requirements and tax consequences with your accountant.
  • US and Foreign Property – We recommend you speak with your financial advisor and accountant prior to purchases of foreign property to ensure you understand the tax and planning consequences.

 

REITs provide tax-efficient cash flow

A diversified portfolio should hold a component of real estate investments.  A personal residence is the first real estate investment for many, but there are others to consider, including Real Estate Investment Trusts.

REITs are a subgroup of the broad income trust category of investments.  The main subgroups of are Energy, Business, and Power & Energy Infrastructure.  On October 31, 2006 the Federal government announced that they would begin taxing trust distributions from Energy, Business, and Power & Energy Infrastructure trusts at regular corporate income tax rates.  These changes will take effect at the beginning of 2011.

This announcement eliminated the advantage of the trust structure as a flow through investment.  The one exception to this required tax change is REITs.  Most REITs are expected to make the necessary adjustments to qualify for the REIT exemption and have their income remain tax-exempt.   There are approximately 34 REITs listed on the TSX and TSX Venture exchanges.  REITs are classified as “financials” from a sector standpoint.  One reason for this is that they are highly sensitive to interest rate movements.

Diversification:  We are essentially attempting to lower overall risk with minimal impact on total potential return.   The main asset mix categories are Cash, Fixed Income, Canadian Equities, US Equities, International Equities and Real Estate.  A question we are asked often is whether or not a personal residence provides the “real estate” component for diversification.  Residential real estate often performs different than other types of real estate investments.  We can analyze investments within a portfolio to determine how closely they are correlated.  Real estate investments often have a low correlation to other equity classes – this may reduce volatility.

Cash Flow:  One of the benefits of income trusts is the ability to provide a steady monthly cash flow.  REITs typically pay monthly distributions and are very popular among income oriented investors.  A REIT collects rent revenue monthly and then flows the majority of this income to unit-holders.

Liquidity:  One benefit to REITs is that they are publicly traded.  They are not locked-in and investors have the ability enter limit and stop-loss orders.  Other real estate type investments are often illiquid, have minimum holding periods, and higher transaction fees.  The best way to determine liquidity is to look at the market capitalization of the issuer (REITS range from a market capitalization of approximately $100 million to $4 billion).

Transparency:  As REITs are publicly traded, they are also audited.  Audited financial statements, and regulatory disclosures provide investors access to important information that has been verified by a third party.  Other types of real estate investments may not have audited statements, independence, or provide access to information.

Taxation:  For those with registered and non-registered accounts we recommend holding REITs in a non-registered account.  Most REITs have a Return of Capital (ROC) component within each monthly distribution making them extremely tax efficient in a taxable account.  ROC is reported in box 42 (information box only) on a T3 slip but is not immediately taxable.

To illustrate we will use a person who buys $20,000 of ABC REIT (2,000 units at $10.00 unit).  ABC REIT pays a monthly distribution of $0.08 per unit.  Annually ABC REIT determines the ratio of taxation with respect to its distributions.  For the current year, 50 per cent of distributions are considered taxable, and 50 per cent is Return of Capital.

The first monthly distribution is $160, of which $80 will be taxable and $80 will be tax deferred (reported in box 42).  The term “adjusted cost base” is often used with investments because your adjusted cost base for “tax” is not necessarily equal to your original amount you paid.

For ABC REIT, the original cost is $20,000.  The adjusted cost base after the first month is $19,920 ($20,000 minus the $80 ROC component).  Provided you do not sell ABC REIT this amount is deferred.  If the investment is held for 3 years, then we would estimate that $2,880 would be applied to reduce the original cost ($80 x 36 months).

If the investment is sold for $20,000 then a capital gain of $2,880 would result.  Remember also that only one half of capital gains are taxable, meaning that $1,440 of the ROC will not be taxed at all.

REITs have three great tax features – initial flow-through from the REIT without being taxed within the trust first; deferral of the ROC component while held; and capital gains treatment upon selling.

Other important points to consider regarding REITs:

  • REIT owners typically cannot file their income tax returns until the first or second week of April.
  • The smaller REITs may have more price volatility.
  • Key components we look for in a REIT are the quality of the properties and management, types of tenants, length of existing leases, payout ratio, and occupancy rates.

The tax benefits of fee-based accounts

Everyone likes paying less tax. And fee-based accounts may provide tax benefits for investors who have non-registered investments.

On Schedule 4 of your income tax return you are able to enter items such as interest expense, safety deposit box charges, and investment counsel fees.  The total is carried forward to Line 221 titled Carrying Charges and Interest Expense.

What are investment counsel fees?

We recommend everyone who has non-registered accounts to read Canada Revenue Agency’s interpretation bulletin (IT-238R2) on this topic.  It is available online online at www.cra-arc.gc.ca or by requesting a copy to be sent by mail 1-800-959-2221. After you have read this bulletin, and looked at your current accounts, you should check with your accountant to see if you are deducting100 per cent of the cost of investing in your non-registered account.

The best way to understand the benefits of fee-based is to compare it to a traditional transactional account.  We will use an investor named Bob who is in the process of setting up a non-registered account after he received an inheritance.  Bob already has an RRSP account where he holds a laddered fixed income portfolio.  Based on our review a transactional account is the most suitable type of account for Bob’s RRSP.  Only a couple of trades a year are required to reinvest maturing bonds within his RRSP.

Bob is interested in buying some individual equities and is unfamiliar with the costs associated with the initial purchases.  We explained to Bob that some investors open transactional accounts, and others open fee-based account.  The term commission is often associated with transactional accounts.  For every trade within a transactional account, an advisor would charge a commission.   The amount some advisors charge for smaller transactions may be around two per cent.  As the dollar amount of the transaction increases the percentage may decline.  Most fee-based accounts are not charged a commission for trading activity.  The fee is based on the market value of the investments within the account.  Some advisors charge a lower fee as the market value increases.  Bob has approximately $500,000 and we will assume his fee is one percent for the illustration below.

Assumptions:

  • Bob has $7,650 and would like to buy Royal Bank
  • Bob buys Royal Bank at $42.86 on January 1
  • Bob sells Royal Bank at $50.00 on December 20
  • Bob is in the 30 per cent marginal tax bracket.

Transactional Account – Factoring in commission, Bob is able to purchase 175 shares of Royal Bank.  The buy confirmation slip for Royal Bank would have a total purchase price of $7,500 plus a commission of $150 (two per cent x $7,500).   The total adjusted cost base is $7,650.  When Bob sells the shares on December 20 the proceeds are $8,750 less a commission of $175 equaling $8,575.   For tax purposes Bob would report a capital gain of $925 ($8,575 – $7,650).  The taxable portion is one half of this, or $463.  Assuming 30 per cent marginal tax rate, CRA’s share is $139.  Most importantly, what did Bob make?  Bob made $786 after taxes and commissions (plus dividends on Royal Bank).

Fee-Based Account – Commissions are not a factor when making purchases in a fee-based account.  We do have to factor in the fee that is paid to the advisor based on the market value of the investment.  One difference you will see right away is that Bob is able to invest the entire $7,650 into Royal Bank as there is no commissions.  Bob is able to buy 178 shares (rather than 175 shares in the transactional account) and still has $21 left over.  The buy confirmation slip for Royal Bank would have a total purchase price of $7,629 and this would also equal the adjusted cost base.  When Bob sells the shares on December 20 the proceeds would equal $8,900.  For tax purposes Bob would report a capital gain of $1,271 ($8,900-$7,629).  The taxable portion is one half of this, or $636.  Assuming 30 per cent marginal rate, the estimated tax on this amount is $191.   We estimate Bob would pay $83 in fees to the advisor relating to the market value of the amount invested.  This fee can be claimed on Schedule 4 and will result in a deduction and tax savings of $25 ($83 x 30 per cent).   CRA’s total share of this transaction is estimated at $166 ($191 – $25).  What did Bob make with the fee-based account?  Bob still had the residual cash of $21 not invested at the beginning plus the proceeds from the investment.  If we estimate the net amount owed to CRA ($166) and the fees paid to the advisor ($83), Bob made $1,022 after taxes (plus dividends on Royal Bank).

Let’s compare the above two options.  Bob made $786 in the transactional account versus $1,022 in the fee-based account.  Bob was further ahead by $236 for this one transaction.  If we assumed Bob had 30 companies in his portfolio with the same situation, annually he would be further ahead by approximately $7,080 with the fee based account.

The above highlights the tax savings of a fee-based account.  The main reason for the difference is that the transaction commissions are higher and they are built into the adjusted cost and proceeds.  This effectively means that only one half of the commissions you pay will ultimately be able to potentially be deductible.  Other factors that influence Bob’s decision are:  type of investment account, level of trading activity, and the types of investments purchased are all key components.  If a person has net capital losses of other years then you should look even harder at the benefits of fee-based accounts.  If every purchase and sell you make in your account excludes commission charges then it increases your chance of having capital gains and being able to utilize both the tax deduction and loss carry forward room.  Another component to factor in is that fees are deducted in the year paid and you do not have to sell your investments.

In Bob’s case the right choice was to have both a transactional account for his RRSP, and a fee-based account for his non-registered account.

Several strategies available to defer paying your taxes

If you can’t avoid tax, the next best thing is to defer it.  There are a few different strategies that are available to take advantage of tax deferral, and it’s often  by correcting the structure of your investments.

Some examples:

Fixed Income

If you have loaned your money to a financial institution, company, or government you have likely purchased some form of fixed income product, such as a term deposit, GIC or  bond.  This category of investment is commonly referred to as fixed income and typically pays interest income.  The only way to defer tax on fixed income is to hold these types of investments within your registered accounts.  By registered accounts we are referring to RRSP, RRIF, LRSP, RESP, and RDSPs.

Equities

Some equities pay regular dividends, often referred to as “blue-chip.”  Not all companies pay dividends.  Growth companies may or may not be profitable yet.  Profitable growth companies may choose to retain earnings for further expansion.  If a company does not pay a dividend then shareholder profits would be derived solely from appreciation in the price of the stock.  Holding growth stocks longer term in a non-registered account is one way to defer tax.

Unrealized Gains

One of the biggest benefits to Canadians is that non-registered investment gains are not taxed until the investment is sold.  Let’s use Charles Young who purchased a growth stock for $14 per share eight years ago in a non-registered account.  Today the shares are worth $27 each.  The appreciation in the value of the stock will not be taxed until Charles sells the stock.  We encourage our clients to take advantage of this tax deferral benefit.  Mapping out a plan to hold certain positions longer term in a non-registered account may make tax sense.  Knowing these rules often allows investors to smooth their income out by controlling when they sell an investment, also known as “realizing.”  Take some time to map out a strategy to hold some of the longer-term positions within a non-registered account.

RRSP Contributions

Contributing to an RRSP is one of the most common ways people defer tax.  By making a contribution to an RRSP in the current year, you are effectively reducing your current tax liability.  In the future, when the money is withdrawn from the RRSP it will be subject to tax as regular income.  The single biggest benefit of an RRSP account is the tax deferral.

RESP

Registered Education Savings Plans are often set up for the benefit of a beneficiary, typically children or grandchildren, but subscribers can also set up an RESP for themselves.  There are no age limits for opening an RESP.

Adults, however, do not qualify for the Canada Education Savings Grant.  Let’s use John and Sarah Sims as an example.

The Sims chose to each make a one-time lump sum maximum contribution of $50,000.  Combined, the  couple can effectively defer investment income on an initial contribution of $100,000 for up to 35 years. This strategy involves a few additional steps that should be discussed with a financial advisor.

Early Contributions

Deferral is enhanced when contributions to your registered accounts are made early every calendar year.   If cash flow permits you should consider moving funds into your TFSA in January and into your RRSP as soon as you know your contribution limit.  Contributing early allows more of the income generated to be tax sheltered for a greater period of time.  Compounding growth on investment returns is enhanced through early contributions.

TFSA

The TFSA is one of the few situations where tax is completely avoided on investment income.  All income is tax sheltered and withdrawals in the future are not taxed.  Anyone interested in deferring investment income should maximize the TFSA contribution each year.

Principal Residence

Building up equity through investing in your principal residence also provides similar benefits to a TFSA.  Gains on your principal residence are generally not taxed at all (note:  losses are also not able to be claimed).  If you purchased a home for $200,000 ten years ago, it may be worth $600,000 today.  The appreciation of $400,000 is not taxable in most cases.

What if a person buys a home today for $600,000 but the value declines to $550,000 in two years time.  In this case, the $50,000 loss cannot be claimed.  All asset classes go through cycles; however, over the long term most people who have purchased a principal residence have benefited from tax-free growth.

Real Estate

Purchasing real estate not considered your principal residence may allow for tax deferral until the property is sold.  If you decide to own more then one home you should speak with your accountant.  Prior to purchasing real estate outside of your principal residence you should understand the risks (especially if debt is assumed) and tax ramifications of all decisions.

In most cases tax cannot be avoided.  However, utilizing strategies to defer tax often provides an ability to enhance your overall net worth.

Exploring benefits of ‘in-kind’ transfers

In many situations, we recommend taking advantage of “in-kind” transfers because they can save taxes and commissions and provide flexibility to investors.

The term in-kind means an investment is moved exactly as is.  This is opposite to a cash transfer where the investment is sold, and cash is transferred.

We are illustrating 10 different examples where an investor may be better off to transfer investments in-kind.

Example #1:  Paul is looking to change financial institutions.  After meeting with Paul we recommended several proposed changes to his portfolio.  We noted that his best option was to open a fee-based account and transfer his existing investments in-kind.  Once the investments are transferred into the new fee-based account then the proposed changes can be done.  With fee-based accounts no transaction commissions are charged to restructure the portfolio.

Example #2:  Elaine’s mother recently passed away.  As an only child she is also the executor and sole beneficiary of her mother’s estate.  Elaine likes the investments in her mother’s estate account and asked us about her options.  We suggested to Elaine that she transfer the investments in-kind into her existing investment account to avoid the selling commissions.

Example #3:  David recently opened a Tax Free Savings Account.  He also has a non-registered investment with several different companies.  We suggested he transfer up to $5,000 in equivalent value of investments in-kind from his non-registered account into his TFSA each year.  He should transfer only investments that have a minimal unrealised capital gain.  The transfer into the TFSA will trigger a deemed disposition for tax purposes for the portion of shares transferred in.   Please note that you should not transfer investments that have an unrealized loss (it would be denied as a result of the superficial loss rules).

Example #4:  Every year John gives money to his favourite charities.  We suggested to John that he would save taxes if he donated some of his investments in his non-registered account in-kind to the charity instead of cash.  By transferring the investment in-kind he would not be taxed on the capital gain portion of the shares transferred.

Example #5:  Every February Joanne has contributed cash into her RRSP account.  This year Joanne is having difficulty coming up with the cash although she had a very high-income year.  We suggested to Joanne that she transfer an investment in-kind from her non-registered account into her RRSP account.  This would enable Joanne to receive an RRSP contribution slip for the value of the investment transferred in (note: superficial loss rules would also apply).  All future growth on this investment would be tax sheltered.

Example #6:  Margaret recently turned 72 years old.  She has sufficient cash flow from pensions but is required to begin pulling a minimum amount from her Registered Retirement Income Fund (RRIF) account.  Margaret does not require the cash flow from the RRIF account.  One strategy Margaret liked was an in-kind transfer from her RRIF account to her non-registered account.  This meant that Margaret did not have to worry about having a specific investment maturing each year equal to her minimum RRIF payment.  She has the flexibility to transfer all or a portion of a position.  She could choose to transfer the equivalent market value of one of her investments, including bonds and common shares.

Example #7:  Tim has deferred sales charge (DSC) mutual funds in his RRSP.  He understands that if he sold the funds they would be subject to a fee.  Prior to selling the funds we suggested he transfer in-kind the DSC mutual fund investments into his non-registered account in exchange for cash – this is often referred to as a swap.  After the transfer is complete then he could sell the funds.  By doing this, Tim could at least claim the loss as a result of the DSC fees once the investments are sold in the non-registered account.

Example #8:  Ellen and Scott are proud parents of a two-year old girl named Eva.  They have some shares in an investment account valued at approximately $5,000 that were given to Eva from her grandparents.  We talked about transferring these shares into a Registered Education Savings Plan (RESP).  The transfer will result in an additional $1,000 (20 per cent x $5,000) cash being credited to the RESP as a result of the Canada Education Savings Grant.

Example #9:  Louise has three RRSP accounts, each of which are charged an annual administration fee.  We noticed duplications in the account.  We discussed to Louise that she could consolidate all three accounts into one through transfers in-kind.  This will reduce her annual cost, as she will have only one annual fee (instead of three).   Her individual positions will also be combined.  Most importantly, the transfers in-kind enabled her consolidated RRSP account to be large enough to consider a fee-based account option with no annual administration costs.

Example #10:  Norman has been investing funds in an informal in-trust account for his disabled son.  We recommended Norman open up a Registered Disability Savings Plan (RDSP) for his child.  By transferring investments from the informal in-trust for account in-kind into an RDSP, he will also receive government grants.

 

Check out the various options for your retirement allowance

The terms retirement allowance and severance pay are essentially the same thing.  Whether you are retiring or losing your job you may be offered some additional related amounts on top of your final employment income.

This additional pay is often confusing for people, especially if they are given options for how the amount is to be paid.   Most people are not familiar with the terms or the outcomes of different choices.  A time frame is often noted on the forms making the choice even more stressful during an emotional time.

One of the first items we review is the tax consequence of the different payments.  Don’t leave this to the last minute.  Spend the time to map out a tax smart plan with your accountant and financial advisor.  As your income may be about to change, a little planning can easily reduce the amount of tax you pay.

Income Tax Act

People who have worked for a company for a long period of time may be eligible to roll a portion of their retirement allowance into their RRSP without using your RRSP deduction limit.  The amount that may be eligible to transfer into your RRSP is outlined in the Income Tax Act and is limited to $2,000 for each year or part of a year before 1996.  For those employed prior to 1989 the limit is increased by $1,500 unless the employer vested the contributions to a company pension plan.  Simply put, if you began working for a company before 1996 you may have an eligible portion.  If you began working after 1995 then you will not have an eligible portion.

Taking advantage of contributing the eligible portion of a retirement allowance to an RRSP generally makes sense, especially if your income will be lower in future years.   Your employer should be able to tell you how much is eligible, in any.

Non-Eligible

If you began working after 1995 for your current company then you will not have an eligible portion.  You may still contribute the non-eligible portion to your RRSP, or to a spousal RRSP, up to your available RRSP deduction limit.   The company paying you the retirement allowance is required to withhold income tax unless you instruct them of your deduction limit and the portion you would like to contribute to your RRSP.

If you provide these instructions to your employer then they do not have to deduct income tax on the amount of the retiring allowance that you transfer to your RRSP.  Using your RRSP deduction limit at retirement is often prudent, especially if you do not have plans for further employment.

Lump sum payments made directly to you are subject to withholding tax.  If the amount is below $5,000 then 10 per cent withholding tax is applied.  If the amount is $5,000 to $15,000 then the rate is 20 per cent.  Amounts over $15,000 are subject to a withholding tax rate of 30 per cent.  The actual amount of tax will be calculated when you file your annual income tax return.

T4A

If you have received a retirement allowance during the year you should ensure you receive a T4A prior to filing your annual tax return.  The T4A will have the income amounts as well as the income tax deducted at source.  The non-eligible portion of a retirement allowance is fully taxable in the year the amount is received.   Both the eligible and non-eligible amounts are reported on a T4A.  The amount of retiring allowance paid in the year should be reported in either Box 26 (eligible amounts) or Box 27 (non-eligible amounts).  It is possible to have amounts in both boxes for the same year.

Timing

Some employers may provide the option for you to receive a retiring allowance as a lump sum payment or to be paid out over two or more years.  If you retire in January then the lump sum payment may be the best choice, as your employment income will be minimal.  Chances are you will have some RRSP deduction limit as well that may be used.

If you retire later in the year then you may be in a situation of high employment income plus a retirement allowance on top of this.  Deferring a portion of a retirement allowance may assist both you and the company.  The company benefits in that they do not have to come up with a lump sum immediately.

Deferring a portion of the retirement allowance may also make sense if you are moving the taxable income from a high marginal tax bracket (if taken immediately) to a lower marginal tax bracket if deferred one or more years.  Your retirement date, current income, future income, and specific details of these payments need to be reviewed.

If you are planning to look for work immediately you should ask how finding new employment might impact the retirement allowance if a deferral option is selected.  In some packages we have reviewed, the deferred retirement allowance is lost if you begin working again.

Retirement Package

Retirement packages should always be reviewed with your accountant and financial advisor.  In some situations, we recommend meeting with your lawyer to determine if the package being presented is fair given your situation.  Retirement packages typically have other important components, such as your pension plan, that also needs to be reviewed.  Planning retirement, or a sudden loss of a job, are two very important “life events” that should always involve your financial advisor.

 

Keep a close eye on your holdings

Recently we had Adam and Betty Gray walk in for a second opinion on their investments.  They brought in their investment statements, comprised of nine accounts with three different financial institutions.  Two of the accounts they had were called managed accounts.  The first managed account statement held Canadian equities and was 10 pages long with over 80 companies, while second statement had another 60 foreign companies.   All of the positions were extremely small.

When we summarized all of the Grays’ holdings we noted that they held over 200 equity holdings.  In some cases we noted that some of the 200 companies were held in different investment accounts.

The Grays had never recorded all accounts in one summary before and were surprised to see the number of companies and the level of duplication.  Certainly, they had felt that they had lost the ability to control what was going on and to react to the rapidly changing economic conditions.

We also asked to see trading summaries and tax returns for the last three years to see how the Grays had recorded realized capital gains (losses).

Here are the comments we had for the Grays:

Average Cost

Canadians must use what is referred to as “average cost” when calculating the adjusted cost base of an investment.  Years ago, the Garys purchased from Institution A, 100 shares of TD Bank at $25 pershare (total cost = $2,500).

Several years later another 100 shares were purchased at Institution B at $45 per share (total cost = $4,500).  More recently, 28 shares were purchased within the Canadian managed account with an adjusted cost base per share of $61 per share (total cost = $1,708).   The adjusted cost base at each institution would not be correct, as they are not factoring in the shares owned elsewhere.  The average cost for tax purposes is equal to $38.19 per share.   The Grays had incorrectly reported some dispositions in prior years by not factoring in average cost.

Superficial Loss Rules

One of the challenges with managed accounts is having the same holdings at different institutions, increasing the likelihood of violating the superficial loss rules.  The superficial loss rules essentially deny a loss if the same position sold at a loss is reacquired within 30 days.  We noted a few situations where Canada Revenue Agency would have denied a loss they had reported.  Luckily they have never been audited.

Diversification

Diversification tends to be a popular word in finance.  The Grays were over-diversified in the number of institutions and individual holdings.  One of the recommendations we had was to consolidate their investments.  We recommended they transfer all accounts in-kind accept for the two managed accounts.  We had estimated the tax consequence of an in cash transfer for the managed accounts and the net result was a net capital loss.   One of the goals we set was to eliminate the duplication so that fewer trades would be required and tax reporting would be easier.

Position Size

In total the Grays had $500,000 in total investments, 60 per cent (or $300,000) of which was invested in equities.   We explained to the Grays that a portfolio with 30 companies ($10,000 initial investment in each company) would provide an appropriate level of diversification.  The Grays had 200 companies, some with as little as $740 and as much as $32,000.  The $740 position size is too small to really benefit from price appreciation.  The $32,000 position size is becoming excessive and is adding unnecessary portfolio risk with little potential for additional return.  By transferring the managed accounts in cash, the accounts will be moving towards the goal of 30 quality companies.

Passive Approach

The Grays had essentially taken a hands-off approach when they opened managed accounts.  They were paying a fee of two per cent to have their portfolio managed.  They understood that the portfolio manager was external to the investment advisor they generally spoke with.  They also understood that the portfolio manager had the discretion to make changes within their accounts.  After the last couple of years, the Grays wanted to do three things:  reduce the cost of managing their portfolio, become more active with their investments, and better monitor their investments.

Reducing Costs

A fee-based account at one per cent was a low cost option for the Grays.  They would effectively be reducing estimated costs from $10,000 currently to the proposed $5,000, representing a $5,000 annual savings.

Active Approach

Most portfolios should have a mixture of longer term hold investments and some trading positions.  We mapped out a strategy for both buying and selling.  We outlined how market and limit orders can be used for both buying and selling.  They also felt that stop loss orders were prudent in some cases to protect profits and limit losses.

Monitoring

Even if you have an investment advisor who is providing you with recommendations, it is important to monitor what is going on.  It became nearly impossible for the Grays to monitor their 200 investments.  By consolidating and reducing the number of holdings, the Grays will be in a better position to monitor their finances.