The importance of tax-smart investing – and how you can do it better next year
It’s tax time again, which means we all have to reconcile our outstanding tax bills with the government. It’s a fun time to be sure! We have all heard the old adage that there are two certainties in life: death and taxes. But, while maintaining our health and survival is woven into our daily routines, we don’t always spend enough time proactively addressing our tax situations. This is known as tax planning, an essential component of how we help our investor clients.
Investing is not just a matter of creating growth or income from your wealth; it’s also about using the best account structures, choosing the appropriate investment types and monitoring your annual tax windows. In other words, it’s about making tax-efficient choices. I’ll get to some examples later.
Just how important is tax planning?
According to the Fraser Institute, taxes accounted for 42% of the average family’s expenditures as a percentage of cash income in 2017. This is enormous and represents the largest overall household cost.
As Canadians, I think we inherently know this to be true and have somewhat become accustomed to our tax reality. More shockingly, perhaps, is that taxes are also the fastest growing expense for Canadians (as per the Fraser Institute).
In light of these two metrics, it would seem logical that there should be ample appetite for tax planning among Canadians at large. As it pertains to investing over the long term, I would argue that the proper tax planning can greatly enhance a family’s net-worth over time. After all, it’s not only about what you earn but also what you keep.
Tax planning is more than just tax deferral. Certainly, the use of Registered Retirement Savings Plans (RRSPs) have their place, with some plan holders earning more today than they expect to withdraw from their plan in retirement. But once you reach an older age and begin to draw from your registered savings, things can get complicated.
Example 1: Old Age Security (OAS) clawback
Some of the investors we have worked with faced issues with partial or full OAS clawback. This begins when your reported net income is at about $77,000 and is fully clawed back when reported net income is about $125,000. Clawback can also result from too much RRIF income or excess savings in non-registered accounts. This is because non-registered accounts can create taxable income every year (unless some strategy is applied). In the work we did recently with a retired client, we were able to defer about $20,000 in interest income from a bond investment within their non-registered account. Not only did this reduce their total net income from near the OAS clawback zone, but it also created extra room from which we could draw additional funds from their Registered Retirement Income Fund (RRIF).
Making use of your annual tax window every year in retirement is important because, as it relates to registered accounts (such as your RRSP or RRIF), upon death, they are generally fully taxable (i.e. the balance of the account is taken into income), unless transferred to a spouse. All investors should consider avoiding too much tax deferral because, unless, you manage the process of drawing down your RRIF, a $300,000 RRIF could be cut in half by tax.
Example 2: Overlooking the power of a Tax-Free Savings Account (TFSA)
Another repeat issue I continue to see among investors is misusing (or not using) a TFSA. The TFSA is a tax holiday from our government, which doesn’t often grant holidays. With a tax-free account, you can benefit from tax-free growth and compounding. Typically, if one of our clients is investing with a goal to grow their wealth, the TFSA is often the ideal account. The logic here is that if a growth investment could double in seven years or so (estimated), then this is a much larger tax-free benefit than having an interest-bearing investment within your TFSA paying you only three per cent a year.
For all these reasons (and more), I very much prefer to collaborate with my clients’ accountants on these matters over time. The tax savings can be considerable and greatly add to the net worth picture over time.
Tax planning can get complicated and everyone’s situation is slightly different, but these are some examples of tax planning logic as it pertains to investments and financial planning.
This information is not intended as nor does it constitute tax or legal advice. Readers should consult their own lawyer, accountant or other professional advisor when planning to implement a strategy. This article is supplied by Nick Hamilton, an Investment Advisor with RBC Dominion Securities Inc. Member–Canadian Investor Protection Fund.