As another tax season comes to an end, I cannot stress again the importance of effective tax planning. Now is the time to think about effective strategies for reducing taxes. Don't wait until next year to plan for this year because it will be too late.
One of the books on my recommended reading list is by a young author, Kurt Rosentreter who wrote 50 Tax-Smart Investing Strategies. He talks about 50 strategies to reduce tax in conjunction with your investment plan. I will highlight 5 of my favorite strategies:
- Know your marginal tax rate and know how investment income is taxed. The higher the marginal tax rate, the more important it is to invest with “tax-smart” in mind. Use growth investments that minimize capital gains. Avoid interest income. Look for dividends and other tax preferred investment income.
- Think after-tax! All thing being equal, if fund A returned 12.5% and fund B returned 11%, you would take fund A over B – right? But consider that fund A returned 10% after tax and fund B returned 10.5% after tax. Now which fund would you choose? Rosentreter says “This focus on after-tax investing is long overdue.” I agree. Look at what an investment earns after paying the tax!
- Avoid year-end mutual fund purchases. At the end of the year, most mutual funds must “clean out” their mutual funds of tax liabilities and distribute them to unit holders. These liabilities result from any dividends and interest earned by the fund as well as any capital gains or losses resulting from any trading in the fund. The danger lies in the fact that the tax liability is distributed to all unit holders on a given date. Even if you happen to buy that fund one day prior to that significant date, you might pay tax for all the income throughout the year even though you didn't earn them. In the end it will work out because it increases your cost base (ACB) but you have to wait to reap the benefits. The moral of the story: be careful about buying funds too late in the year!
- Make your interest tax deductible. Debt is wise if used effectively. One of the ways to make it effective is to make it “Tax-smart” by making the interest tax deductible. Here is an example of how this is done: Sell some of your existing investments to pay off debt that is non-deductible like a mortgage or personal line of credit. Then, re-borrow with the specific intent of investing. Make sure your financial institution knows that the loan is being used for investing purposes to protect yourself. Now the interest is tax deductible.
- Consider universal life insurance. This strategy is not for everyone, but if you maximize your RRSP every year, you are reasonably healthy, you have at least a 7 year time horizon, you are paying tax on investment income and you have disposable income to invest, you are in the perfect situation to consider the tax benefits of Universal Life. Unfortunately, there is too much to say in too little of a space so I will simply advise to talk to your financial advisor if you fall into these characteristics.
Remember that there are only five strategies here out of 50 in Rosentreter's book and even more than that available to even the average Canadian. It is a myth that only the rich have access to tax strategies. The reality is the rich become rich because they are aware of these tax strategies and actually plan ahead to take advantage of them.
To that, I'd like to add five more strategies I know will help you every tax season.
- Marginal tax rate. Knowing your Canadian tax brackets is the foundation of good tax planning. Knowing how much tax you pay will also help you to understand the value of many tax saving strategies.
- Income splitting strategies. Income splitting refers to the strategy of moving income from one family member to another. Ideally you only want to do this if you are moving income from a higher marginal tax rate to a lower marginal tax rate. Some of the most common income splitting strategies are utilizing spousal RRSPs, investing in the lower income earner's name, buying RESPs, and for seniors splitting CPP.
- Understand investment income. Far too often, investors look at what I call ‘surface returns'. Consider this example: imagine that there are two investments, one paying 10% and the second paying 8%. Which one would you choose? This is not a trick question but it does illustrate what I mean by surface returns. The returns you see here in this example and in the newspapers are all surface returns, which means they do not take tax into account. What if these same investments produced after-tax returns of 6% and 7% respectively? Now which would you choose? Be sure to understand the after tax implications of an investment. Some tips include looking for investments that generate capital gains and dividends over interest income, buy and hold mutual funds and mutual fund corporations.
- Take advantage of tax deductions. As I mentioned last week, a deduction is a claim to reduce your taxable income. The value of a tax deduction is equal to your marginal tax rate. For example, if you earn $40,000 per year and contribute to an RRSP. That RRSP deduction is worth 32% in tax savings. RRSPs are the most common strategy for tax deductions. Other deductions include pension contributions, union and professional dues, child care expenses, moving expenses, support payments, and interest expense (for business or investing).
- Utilize medical and charitable credits. Be sure to save medical and charitable donation receipts. Both these expenses can be significant tax savings habits. These credits can be transferred from one spouse to another.
Unfortunately, it is difficult to get into a lot of detail here but do not be afraid to seek the help of a professional. Otherwise invest in one of my favorite tax books called ‘Winning the Tax Game' by Tim Cestnick. It might be one of the best $25 investments you can make!
And so the cliché once again makes sense: If you don't know where you are going, any road will get you there. Be sure to plan ahead to ensure that you are utilizing tax savings strategies.