Financial tips for blended families

Opening the communication channels is key when helping couples in blended family situations.   This communication should absolutely start on Day 1 for blended families, and should be part of the account opening process. A good advisor will ask probing questions beyond the checklist of mandatory questions to first open an account.  

With new blended families, it is not always easy to have open communication with both parties. Often, they have different advisors and different financial institutions.   If this is the case, then it is common for the couple to maintain the status quo with their separate finances.   I always encourage couples in blended families to come in together, even when they are maintaining separate finances. Once this happens, and once there is open discussion and communication, then progress can be made on a variety of financial decisions.

Often there is a disparity between the value of assets, or net worth, of each party. Rarely are the assets equal. One party may have more equity in real estate, while the other has more stock and bond investments.  

Making objective financial decisions can be challenged by the simple notion that “blood is thicker than water.”   For example, many parents want to provide for their children from a previous marriage. However, this can conflict with the many tax benefits provided for married or common-law relationships. This conflict is especially challenging when it comes to estate planning. Below I have listed a few common assets and basic challenges couples in blended families may face.

Non-Registered Account:  The term taxable account or non-registered can be used inter-changeably. Often young people do not have non-registered accounts as they are busy paying off mortgages and/or contributing to their registered accounts, such as RRSPs.   Older couples with adult children are more likely to have taxable accounts when they enter a blended family.   When a person has non-registered investments just in their name, this is called an Individual Account.   The monthly statements and confirmation slips have just the one person’s name on it, and the year-end tax slips (i.e. T5 and T3 slips) are in same one individual’s name.  

Couples in a first marriage, and who have built up equity together, will open up a taxable account called Joint With Right of Survivorship (JTWROS). This type of account has many benefits for couples, including income-splitting. The primary benefits of these joint accounts are probate is avoided, income tax continues to be deferred, such as for unrealized capital gains, and simplicity of paperwork after the first spouse passes away.  

Some couples have two JTRWOS with each person being primary on their own respective account. By primary I mean their name is first on the account and their social insurance number is on all tax slips. This enables couples to still keep funds separate, but it will still provide the same above benefits.

Tenants in Common:  Another option for taxable accounts is Tenants In Common. With Tenants in Common a taxable account is set up with two or more owners, where the ownership percentages do not have to be equal. Upon the passing of any owner, their portion represents part of their estate, and the other owners do not have the right of survivorship.   Many of the benefits of JTWROS are lost with Tenants In Common, but for some couples this may be the right decision. A couple that would like to combine their assets to pay household bills, could simply allocate the ownership based on the amount originally contributed. If Spouse ”A” puts in $300,000, and Spouse “B” puts in $700,000 then the allocation for ownership could be 30 per cent for Spouse A and 70 per cent for Spouse B.   If either spouse passes away, their Will would dictate how their proportionate share is divided.  

Registered Accounts:  The two most common types of registered accounts are Registered Retirement Savings Plans (RRSP) and Tax Free Savings Accounts (TFSA). RRSP and TFSA accounts can only be in one person’s name.  

However, with both of these types of accounts you are able to name a beneficiary. With couples in a first marriage and building equity together, your spouse is likely always named the beneficiary on registered accounts.   At the time of death, Canada Revenue Agency allows the owner of an RRSP (called an annuitant) to transfer their RRSP to their surviving spouse or common-law partner, on a tax-deferred basis. If there are financially dependent children because of physical or mental impairments, then it also may be possible to transfer the annuitant’s RRSP on a tax-deferred basis. Outside of these two situations, the annuitant’s RRSP is fully taxable in the year of death.

A person who has a spouse, and chooses to name an adult child the beneficiary should understand the tax consequences. If you name your spouse the beneficiary, your spouse receives 100 per cent of the value until the funds are pulled out gradually (taxed when taken out). If you name someone other than a spouse, the funds are deemed taxable in one large lump sum, so the marginal tax bracket of 45.8 per cent could easily be reached. Many people would cringe if they could see the amount of tax paid to CRA from RRSP accounts resulting from a lack of planning.  

Although the TFSA has no immediate tax issues on death, there are still some benefits to naming your spouse or common-law partner the beneficiary.   As an example, let’s look at a blended family with Spouses C and D. Spouse C has $48,000 in a TFSA and Spouse D Has $52,000.

Spouse C has the option of naming the Estate the beneficiary, naming Spouse D the beneficiary, or naming another individual such as a child or children from a previous marriage. If Spouse C names the Estate the beneficiary, then the account would likely have to be probated to validate the Will. The Will would provide us direction as to who the beneficiary of the TFSA will be. If Spouse C named Spouse D the beneficiary, then we can roll over the entire $48,000 into Spouse D’s TFSA account (without using contribution room). After the roll over, Spouse D would have a TFSA valued at $100,000 – all of which is fully tax sheltered. The roll over can be done once we receive a copy of the death certificate – and no probate is required for the transfer of assets. The only time individuals are permitted to put more into their TFSA accounts, other than their standard annual limits and replenishing amounts withdrawn in an earlier year, is when their spouse or common–law partner passes away and they are named the beneficiary.

If Spouse C named the children from the first marriage the beneficiary, then Spouse D does not get the additional room and the children could receive the funds but would not be able to roll this amount into their own respective TFSA accounts without using their available room.  

While there are many solutions available for blended families, it is important to talk about these options and then document the plan.   Gathering all the information and creating a plan that both parties are content with can take some time. A plan should include all standard types of assets such as personal residence and vehicles, as well as liabilities. One of my most rewarding moments as a Portfolio Manager is assisting my clients with their plan. A plan ultimately provides peace of mind for clients in what is often viewed as a complex situation that was either too sensitive to talk about or simply not addressed.

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.

Another good reason to have an accountant – Rules change on foreign reporting

In 1997, the Canada Revenue Agency (CRA) proposed changes on how foreign property is reported. In 1998, CRA introduced the reporting of certain foreign property by requiring all Canadian tax filers to answer, “Did you own or hold foreign property at any time in 1998 with a total cost of more than CAN $100,000?” If you answered “yes” to this question then you were required to complete a “Foreign Income Verification Statement” – CRA and accountants refer to this form as T1135. In my experience, the biggest misunderstanding people have relates to the term “foreign property” and what is included and excluded. An accountant is invaluable in providing guidance in complex areas such as these.

Since 1998, modifications have been made to the T1135 but the form was relatively easy to complete as CRA provided broad monetary ranges for disclosure (i.e., $100,000 to $300,000; $300,000 to $500,000; etc.) and broad categories (i.e., shares of foreign companies without the name of the companies or the investment firm, real estate without the specific location, bank accounts without the name). This information was all that was required, along with a general indication of where the foreign property was held.

In June 2013, CRA released a new version of T1135, to be applicable for 2013 and later taxation years. CRA then delayed its application so that it would only apply for taxation years ending after June 30, 2013. The new version of T1135 was very detailed and many tax practitioners felt it was too onerous. The new T1135 required more detailed information on each specified foreign property. The additional information would require the following for each specified foreign property: name, country code, institution, maximum cost during the year, year-end cost of the property, income or loss, and capital gain or loss.

Accountants and financial advisors were sorting out the logistical nightmare of these new requirements. Many individuals who prepare their own income tax returns are likely unaware of the new requirements or the penalties for not complying.

After listing the new requirements, CRA complicated it further by providing exclusions from the detailed reporting, including specified foreign property where the Canadian resident received a tax slip (T3 or T5). CRA provided different options with respect to how the new T1135 form could be completed (i.e. standard reporting method versus transitional reporting method).

Near the end of February 2014, CRA announced new transitional relief for Canadians who must comply with the more detailed T1135 information reporting. At this stage, the transitional relief applies only for the 2013 taxation year. This relief is only allowed for investments that you received a T3 or T5 for the income. Other investments that issue slips such as a T5013 do not meet the exclusion and must be listed in detail. This relief is intended to assist taxpayers in transitioning to potentially the more onerous reporting requirements in future years. The transitional relief will allow CRA time to respond to concerns raised by Canadian residents.

One of these reliefs relates to individuals who have foreign property held in non-registered investment accounts with Canadian securities dealers. Rather than reporting the above details of each specified property individually (i.e. each individual stock), investors are able to report the combined “market value” of all such property at the end of the 2013 taxation year.

To illustrate we will use John Smith whose only foreign property is the 30 US stocks he holds in non-registered account 999-99999 with ABC Financial. For illustration purposes only we also assumed that the T3/T5 reporting exception is not being utilized for any specified foreign property. As of December 31, 2013 Mr. Smith’s book value on his USD investment account is $150,000 USD, and the market value is $250,000 USD. The USD to CAD dollar exchange rate on December 31, 2013 is 1.0636 per the Bank of Canada website. The USD to CAD dollar average exchange rate for 2013 is 1.0299148 per the Bank of Canada website. Mr. Smith received a T5 slip totaling $9,000 USD in income on his US dollar denominated account. Mr. Smith’s investment advisor sent him a realized gain (loss) report showing a net realized gain on 2013 dispositions of $14,300 CAD on his US holdings. The first step is to determine if the “book value” of certain foreign property exceeded $100,000 CAD at any time during 2013. Mr. Smith’s case is easy as his book value clearly exceeded $100,000 CAD on December 31, 2013 – he is required to file the T1135. The 2013 relief mentioned above allows Mr. Smith to greatly simplify the reporting with respect to his US dollar brokerage account in section six of T1135. Under Description of property he can enter “ABC Financial Account # 999-9999”. Under Country code he enters CAN even though he owns stocks in the US and other countries. Under Maximum cost amount during the year he can enter “0”. Under Cost Amount at year end he enters the “market value” in Canadian dollars of the account at the end of 2013 which is $265,900 (calculation: market value $250,000 US x year end exchange 1.0636). Under Income (loss) he enters the converted amount of $9,269.23 (calculation: income $9,000 USD x average exchange 1.0299148). Under Gain (loss) on disposition he reports the $14,300 amount from the realized gain (loss) report that his advisor already sent him which is denominated in CAD dollars.

The above analysis should not lead people to do the form themselves unless they understand all the reporting requirements thoroughly. It is by no means a comprehensive explanation of the revisions. I would strongly urge any person who has foreign holdings (outside of registered accounts) to discuss their reporting obligations with their accountant and advisor. Under the CRA website (cra-arc.gc.ca) you can search for T1135 (and other foreign disclosure forms) to obtain general information and answers to commonly asked questions. The website also has a table of penalties for not filing various disclosure forms applicable to your situation. As an example, Mr. Smith could be fined $25 per day (up to a maximum of $2,500) for not filing the T1135. If CRA feels that Mr. Smith knowingly didn’t file the form the maximum fine is $500 per day (up to a maximum of $12,000). The penalties above can also apply to prior years, albeit the prior year’s forms were relatively simple to complete and the taxpayer may have innocently not filed because they were unaware of the requirement to file.

The deadline to file Form T1135 has been extended to July 31, 2014 for all taxpayers. Currently, the T1135 form cannot be electronically filed. Most tax correspondence on Vancouver Island goes to the Surrey Taxation Centre; however, the paper copy of this form must be mailed to the following address: Ottawa Technology Centre, Data Assessment and Evaluations Program, Verification and Validation, Other Programs Unit, 875 Heron Road, Ottawa ON K1A 1A2.

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.

It’s that time: Tips on filing tax returns

Every year, more and more Canadians are preparing their returns using discount tax software.  It  links cleanly to the Net File process that eliminates having to mail your return to Canada Revenue Agency.     

For many basic returns, where all you have is your T4 and T5 slips, preparing your own return with tax software takes very little time.  The CRA website is a good reference for individuals at home wanting basic information on your tax return. Go to http://www.cra-arc.gc.ca/menu-e.html where you can select individuals and families. 

You can sign up for My Account, which allows you to track your refund, view or change your return, review income tax slips, check your benefit and credit payments and check your TFSA  and RRSP limits.  You also have the ability to set up direct deposit, though I don’t encourage it for individuals still working or those who own a business. 

If your situation is not basic, or you’re not sure if you are taking advantage of all tax credits, then you should find a qualified accountant if you don’t already have one.  If you have a business, or are uncertain on how to do your tax return, then you will find the services of a good accountant to be invaluable, especially as they save you the headache of fixing a tax return not initially prepared properly.  Your accountant will also ensure you are minimizing tax and taking full advantage of tax credits.  Fees paid to your accountant for tax advice are generally deductible while the cost for personal income tax software program is not.   

One tax tip could easily result in significant tax savings that would offset the cost of having your tax return professional prepared.  For those individuals using a tax preparer, I recommend you fully complete any questionnaires or checklists that they may have sent to you at the beginning of the year. 

If you are an employee who can deduct some employment expenses, print off a T777 tax form from the CRA website and organize your receipts and expenses accordingly.  Fill in the T777 as a draft version for your accountant to review.  If you have a small unincorporated business, print off the appropriate tax schedule and organize your receipts and expenses according to the same categories.  If you have marketable securities we recommend that you have your advisor prepare a realized gain-loss report to reduce the time your accountant needs to spend on this part of your tax return.  Giving an organized package to your accountant will ensure that the time they spend on your return is utilizing their professional knowledge rather than the administration of organizing receipts. 

In the years when I worked in public practice as a Chartered Accountant, I would have a range of packages dropped off.  Some were dropped off too early and were still missing slips.  Others were dropped off too late and fees and penalties would apply.  In some of the worst cases, I would receive a box full of receipts that had no organization to them.  Information delivered at the right time in an organized manner lowered accounting fees. 

One of the key steps accountants do is a comparative analysis of what you reported last year versus the current year.  As an example, if you had four T5 slips (for reporting dividend and interest income) last year and you only have two this year, your accountant should be asking why.  A big step that can assist your accountant (especially if your accountant is new) is to include your prior year’s tax return with your current year information with an explanation for any differences. 

I recommend you go through your slips from the prior year and compare to the current year.  You should have an explanation for why, such as consolidated investments, retired or sold investments in the prior year. 

If you have changed investment firms during the year, I recommend you take extra caution at this step as you are likely to get twice the slips that you previously had for the year of change.  Talking to your new financial advisor should assist you in obtaining a list of all the slips that you should be expecting.  Some of these slips are sent by the financial firm you are dealing with and others may be sent directly from the company that you invested in.

Whether you use an accountant or prepare your own tax return, it always pays to stay organized.  Set up a file system that either has copies of your current and past returns.  In many cases, files and documents are being converted to electronic form, which should be backed up periodically to prevent loss of data if your hard drive fails or you get a new computer.

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. 

Fee-based accounts benefit investors in the long run

A fee-based account is a tranparent way of paying your financial advisor.  The fee is charged based on the market value of the assets being managed, and it is distinctly different than a transactional account, where commissions are charged for every buy-and-sell transaction. 

When clients open up a fee-based account, they sign a fee-based agreement that establishes the agreed upon fee, how the fees are calculated, when the fees will be charged and the accounts involved.   

There are a number of benefits for clients in moving to a fee-based account. 

Working on a “fee for service” basis, rather than a commission or transactional fee basis, means the best interests of the client are more aligned with those of the advisor. If fees are based on the market value of the account, then the only way an advisor will be compensated further is if they can grow your account in value.  If your account declines in value, then so does the compensation paid to your advisor.  

Another benefit of a fee-based account is the additional services clients receive from their financial advisor.  Financial professionals today are rarely called stock brokers because the services offered extend well beyond buying and selling stocks. Financial planning meetings cover many topics such as tax and insurance as well as education, retirement and estate planning. 

Financial professionals today spend a significant amount of time understanding each client’s needs and integrating this into an increasingly complex tax and regulatory environment. 

As a result, the amount billed for fee-based accounts is referred to as an “investment council fee” for income tax purposes.  The main benefit is the fees relating to non-registered accounts can be deducted on your income tax return as a carrying charge.  If your fee is one per cent before tax, and your marginal income tax bracket is 30 per cent, your fees have a net cost to you of only 0.70 per cent.   

Fees are typically charged quarterly. As an example, Jane Wilson opened a new fee-based account and invested $750,000 on Jan. 1 with an annual fee of one per cent.  She will have no fees charged for three months. Around the middle of April, the first quarterly fees would be charged at $1,875 ($750,000 x 0.25 per cent).  Wilson’s fees are one-quarter of one percent after each quarterly period. 

Other methods of compensating that are not fee-based often have commission charges upward as high as five percent on the first day of buying the investments. For an advisor to be successful with a fee-based business, he or she needs to establish good long term relationships. 

The periodic payment of fees better aligns the interests of clients and financial professionals.  When explained to clients, most would prefer to spread out the fees over time as services are provided versus paying a large amount on the first day.  

One question we are asked is how the quarterly fees are actually paid.  To illustrate we will use Don Spalding, who has three investment accounts totaling $750,000 – $500,000 in a non-registered account, $200,000 in his RRSP account, and the remaining $50,000 is in a Tax Free Savings Account. 

There are a few different options for how Spalding can cover the quarterly fees. 

The first option is to have the fees charged to each of the respective accounts.  Wilson had only one account and the fee of $1,875 was simply charged to that one account.  Mr. Spalding has three accounts and each account is charged the respective amount based on one-quarter of one percent of the market value of each account. 

The first quarterly amount for Spalding is $1,250 for the non-registered account, $500 for the RRSP, and $125 for the TFSA.  He has the option of keeping cash in each account to cover the fees, depositing cash quarterly or selling investments. 

With fee-based accounts, Spalding has the option to instruct us to designate the billing of the fees to come out of one account.  Don could instruct us to pay the fees for his RRSP and TFSA accounts from the non-registered account.  This enables him to maximize the amount he maintains in his registered accounts keeping it tax sheltered. 

The payment of fees from a designated account enables an advisor to fully invest the non-designated accounts and to utilize compounding growth strategies such as the dividend reinvestment plan.  Fee-based accounts can assist with income splitting as the higher income spouse can pay the account fees of the lower income spouse.

Liquidity is another benefit of fee-based accounts.  As there is no cost to buy investments, the same applies to changing or selling investments.  If you require money for any reason, there is no commissions payable for selling or rebalancing your investments.  Rebalancing can include reducing a position that has performed well, dollar cost averaging on a position that has underperformed, adjusting sector exposure, modifying asset mix, and changing the geography of your investments. 

Another benefit of fee-based is the ability to link additional family members to the platform.  Clients with children and grandchildren often would like introduce them to the benefits of full service brokerage, but do not individually have the capital to be able to open accounts on their own.  This could include parents wishing to assist adult children in opening and funding Tax Free Savings Accounts and grandparents who wish to open Registered Education Savings Plans for their grandchildren.  Fee-based accounts that are linked can make wealth transfer strategies within the family group of accounts significantly easier.

Tips on dealing with tax instalment payments

Most people who are employed with one company, and have no other sources of income, do not have to worry about making instalment payments. Employers have an obligation to withhold appropriate income tax from their employees. At the end of the year, the T4 slips report the total income earned along with the total amount of income tax already withheld by the employer at source and periodically remitted to Canada Revenue Agency (CRA).

There are situations where individuals have income from activities other than employment. In many of these cases, tax is not withheld at source, meaning that you may have to pay tax at the end of the year. Examples of situations that can result in instalment payments include: self-employment income, RRIF payments, Old Age Security payments, Canada Pension Plan (CPP) benefits, rental income, certain pension income, and investment income. Individuals who work more than one job may also have an insufficient amount of tax withheld, as each employer has based the withholding tax on payroll tables and income from the one job.

If the above sources of income do not create a tax liability, then no instalments are necessary. If however, your net tax owing is more than $3,000 in the current year, or in either the previous two income tax years, chances are CRA will be sending you an instalment reminder notice. The notice will map out the required income tax payments that CRA requests on the following dates: March 15, June 15, September 15, and December 15. If these payments are missed, and taxes are owed at the end of the year, then interest and penalties may apply.

The instalment payments are to cover tax that you would otherwise have to pay in a lump sum on April 30 of the following year. Instalments are not paid to CRA in advance, but are paid throughout the calendar year (on the dates noted above) in which you are earning the taxable income. The tax instalments are requested because either no tax is withheld on some of your income or the income tax is being withheld is not sufficient.

Speaking with a financial advisor and accountant about instalment payments can often result in some helpful tips on ways to reduce your net tax owing, or even eliminate the need to make the CRA scheduled instalment payments. The easiest way to reduce your net tax owing is by voluntarily making instalments in those years where you know you owe tax. Other easy ways include having tax withheld, or by increasing the amount of tax withheld, from certain types of income. We will use three different individuals (John, Susan, Wayne) to illustrate three ways to avoid the scheduled CRA instalment payments.

John is turning 65 and he will soon collect both Canada Pension Plan (CPP) and Old Age Security (OAS). In talking to John we explained to him that the monthly CPP and OAS payments will be automatically deposited into his bank account on set dates near the end of each month. We also discussed with John that the default for these monthly payments is to receive the gross amount each month. We will assume for illustration purposes that the gross monthly CPP and OAS amounts are $600 and $550, respectively. Combined, this will increase John’s income by $1,150 per month or $13,800 per year. He is in the 30 per cent income tax bracket and the projected additional tax will be $4,140. One option John has is to visit a Service Canada office and request Form ISP-3520, Request for Voluntary Federal Income Tax Deductions Canada Pension Plan (CPP) and Old Age Security (OAS). A copy of this form can also be obtained by calling toll-free 1-800-277-9914. On this form, John can request that Service Canada deduct a specific amount, or percentage, of income deducted from each monthly payment. Form ISP-3520 can also be used to change the amount or the percentage at a later date. The form takes one or two minutes to complete. As an example, John can request that 30 per cent be withheld from both the gross amounts of $600 (CPP) and $550 (OAS) for income tax. Every month, John would receive net amounts of $420 (CPP) and $385 (OAS), which is net of income tax withheld. At the end of the year, both the CPP and OAS income tax slips would show a combined $4,140 of income tax withheld. John doesn’t have to scramble the following April to find money for income taxes, and also eliminates the need for John to make quarterly instalments the following year.

Susan is a very busy realtor but like many realtors has good and bad years. Some years, her income is very high and in other years her income drops significantly. Budgeting is critical for Susan because of her cyclical earnings. She is self employed and the commissions she earns on her real estate transactions can result in a significant income tax liability at the end of the year. Susan and her accountant have mapped out a good system that estimates the amount of tax that she will pay on her net income. Proactively Susan sends in payments to be applied to her instalment account for the current year to reduce her net tax owing to less then $3,000. This is Susan’s method of ensuring tax is set aside and also eliminates the need to make quarterly instalments the following year.

Wayne turned 71 last year and converted his Registered Retirement Savings Account (RRSP) to a Registered Retirement Income Fund (RRIF). Wayne’s RRIF account value at December 31 last year was $500,000 and his minimum RRIF payment this year is 7.48 per cent of $500,000 or $37,400 ($3,116.67 monthly). In talking to Wayne, we explained to him that the minimum RRIF payment is not subject to income tax at source but is taxable at the end of the year. Wayne is in the 30 per cent income tax bracket and we estimate that at the end of the year he will have $11,200 of income tax to pay ($37,400 x 30 per cent). This would trigger Wayne to come up with the lump sum tax by April 30 and he would also receive an instalment reminder to make instalments in the same year on March 15, June 15, September 15, and December 15. We recommended that Wayne have us withhold 30 percent of his monthly RRIF payments for income tax purposes. No specific form needs to be completed for the withholding to be set up, just verbal authorization from the client to the advisor. Wayne would receive $2,181.67 each month. At the end of the year, Wayne would receive a T4RIF income tax slip showing gross RRIF income of $37,400 and income deducted of $11,220. By setting up a set withholding amount (which does not have to be 30 per cent) then Wayne avoids having to make quarterly CRA instalment payments. Wayne can also cancel or change the withholding at a later date.

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.

TFSA equities can yield big dividends

Many people are still keeping their Tax Free Saving Account in cash or in a low interest bearing vehicle, not realizing there are other options available.

There are plenty of advertisements this time of year encouraging people to open new accounts with the promise of teaser high interest rates for six months or a year, or a $50 bonus. Seems like a no brainer to sign up for the new account, right?

Regrettably, many are missing the fine print where it is disclosed there is a $125 fee should you decide later to transfer. Those teaser rates don’t last forever, and the firms offering the teaser rates may have limited investment options.

Your TFSA is not limited to just cash. There are other investment product options available, such as equities. Managing equities in your TFSA is a little riskier, but the potential for bigger dividends should offset this risk.

You can have as many TFSA accounts as you wish provided they do not go over the annual limits. The Canada Revenue Agency is on top of people who over-contribute. When the TFSA was first launched, the CRA were more lenient on waiving interest and penalties for those who inadvertently over-contributed. The penalties and tax are severe and could quickly wipe away any benefit of the TFSA if you make an over contribution.

My advice for anyone with a TFSA is to have only one and to have a strategy for the account.

By maintaining one TFSA, you can easily manage the amount you contributed and you don’t have to remember all the details of each of your other TFSA accounts. I also recommend that the TFSA account is with the same advisor and financial firm as your other investment accounts. The investments within the TFSA should have a strategy and should compliment your other investment holdings. Your financial advisor will also have the financial planning software that has been updated in recent years to include the impact of contributing to a TFSA over time.

On March 23, 2011, I wrote an article about having a conservative blue chip stock in the TFSA. I illustrated this using Clare, who purchased TransCanada Corp (TRP). In the article, we assumed that Clare purchased shares in TRP with her maximum contribution limit at the beginning of each year. The maximum contribution amount for 2013 was raised to $5,500, so as of February 28, 2013, Clare’s TFSA is valued at $34,103.

Back in 2009, Clare’s husband, John, chose to buy Royal Bank of Canada (RY) shares instead of TRP. Every year, John has added to his Royal Bank shares in his TFSA by simply transferring shares that he already owns in his non-registered account. He understands with each transfer from his non-registered account that he has to pay tax on the realized gain from the shares transferred into the TFSA. Similar to Clare, John has built up a sizable TFSA using one stock. The strategy was suitable for John and Clare as they wished to hold equities within their TFSA, have combined investments of $1 million, and wished to assume the concentration risk in one account.

Together John and Clare have seven accounts – two joint with right of survivorship non-registered (one with John as the primary, and the other as Clare as primary), two TFSA, two RRSP, and one locked-in RRSP (resulting in the transfer of a registered pension plan from John’s former employer).

John and Clare could see the benefits of having their TFSA accounts at the same institution of their other holdings. We were able to ensure that the investments in the TFSA are complimentary to the other holdings they have and to manage overall position size of each investment.

Sixty per cent of John and Clare’s total investments are in equities, or $600,000. For John and Clare’s combined portfolio we have recommended 30 equities with initial positions being approximately $20,000. John and Clare’s TFSA accounts have investment risk tolerance set at high on both accounts as a result of their concentration in one holding.

If the position exceeds five percent of the portfolio, we would recommend reducing the position, also called rebalancing. If John and Clare wish to continue holding an investment that exceeds five per cent or $50,000, we would have them sign a specific letter stating that they understand the risk associated with more concentration in this investment..

During our March meeting, we suggested that John and Clare each consider selling half of their shares and buying a second stock in a different sector that compliments the total portfolio. Individuals that wish to have equity exposure within their TFSA accounts should understand the associated risks of concentrating and different options of investing.

Investors with less capital than Clare and John or who have a lower risk tolerance, should look at a different approach for the TFSA. Once investors obtain a total portfolio of $250,000 or greater, then I encourage people to look at the benefits of direct equities within a TFSA.

Let’s use a household with total investments of $250,000 with 60 percent in equities, or $150,000. In this case we would recommend 20 equity holdings at $7,500 each. The TFSA would likely have three to four companies. Capital gains and income are “tax free” in a TFSA. Losses within a TFSA cannot be claimed.

In other words, if an investment goes down in value more than the income it has generated, it would have been better off to hold it in a non-registered account to be able to have the loss carry-forward.