Tax Planning

Taxes influence every aspect of your financial management from employment income to investment income, retirement income and estate planning issues. Your tax bill is likely your single biggest expense every year. However there are a few ways to effectively save you taxes that you may not be aware of…..

• Attribution Rules: Finding ways to reduce taxes
• Corporate Class Funds
• T-Series Funds
• Tax Free Savings Accounts

Tax Planning 101

Like most people navigating through our tax return is right up there with going to the Dentist. Unfortunately, there is no way around many of the headaches that the tax system brings on.

Let’s take some time to familiarize ourselves with Canada's tax system and with a little effort, you may be able to ring up some substantial gains. Knowing how the tax system works means you can take advantage of the many legitimate opportunities for minimizing the tax you pay.

The first place to start is last year’s tax return to see how much tax you actually paid. On the federal T1 General form, start with the sum on line 435, which is total tax payable. Subtract any credits deducted from your total tax payable but don't take away the credit for income tax you've already deducted that's on line 437, or the tax you paid by installments which is on line 476. Now get out your pen and write down the resulting number down—that’s how much you paid in tax last year.

Some more tax basics...

• Your Marginal Tax Rate
• Tax Deductions and Tax Credits
• Attribution Rules
• Taxes and Your Investments
• Minimixing Taxes Using RRSP's
• Year End Tax Planning

Your Marginal Tax Rate

In most cases, your total tax payable means paying CRA one of your biggest expenses last year. The good news is, and yes there is good news, if you spend some time making sure you're taking advantage of all your available deductions and credits, and implement some tax-planning strategies you may be able to reduce a significant amount off your tax bill.

One of the key concepts to our tax system is your marginal tax rate. There are two tax rates that you'll need to know about. When you see the tax deduction on your paystub there is only one figure. If your income goes up, so do your taxes. When you make less money, you pay less tax. This is what is known as a progressive tax system.

Based on a progressive tax system not every dollar you make is taxed at the same rate. There are four federal tax brackets, and different portions of your income are taxed at different levels.

When you pay tax, whether it's deducted from your pay, you submit it for a business, or you send the Canada Revenue Agency a check at tax time, the numbers are added up and presented to you as if you were paying the same rate on every dollar you make. This is known as your effective tax.

Your marginal tax rate is the rate at which the last dollars you earn in any year is taxed. For example, if you make $62,000. Your marginal tax rate would be 43 per cent. In other words, if you made an extra $1,000, you'd have to give the government $430. But suppose your income is $4,000 less, or $58,000 a year. Then your marginal tax rate would only be 33 per cent. So if you made that extra $1,000, you'd only have to pay $330 in tax, leaving you with an extra $100.

* Based on top personal income threshold of $ $126,264
* Combined Federal & Provincial Tax Rates for 2009 (includes surtaxes where applicable).

Tax Deductions

The more money you make, the higher your tax bracket, and the more tax you pay. And that means the higher your tax bracket, the more a deduction is worth to you.

For example, if you were in the lowest tax bracket of 21% and you had a $2,000 deduction for moving expenses, you could deduct that from your income before your taxes were calculated. The savings to you would be the tax you would otherwise have had to pay on that $2,000 which is $420.

Now let's consider that you're in a 50% tax bracket. That same $2,000 deduction would be worth $1,000 of tax savings. In short, a deduction saves you exactly the amount of the deduction multiplied by your marginal tax rate.

Tax Credits

Unlike a deduction, a credit does not reduce your taxable income. Instead, it comes into effect once the amount of tax you owe has been determined. For example, let's say you owed $10,000 in federal tax. If you had a $1,000 tax credit, you would simply deduct this from your federal tax payable, reducing it to $9,000.

Deductions are expenditures that can be reduced from your overall income for tax saving purposes. Examples include RRSP contributions, alimony, child care expenses, union and professional dues.

With tax credits, your marginal tax rate doesn't come into play at all. The result is that a tax credit is worth the same in real dollars to everybody, regardless of their income level and tax bracket.

For the most part tax credits are subtracted from the amount of basic federal tax you are required to pay. Since your provincial taxes and federal surtaxes are calculated on your basic federal tax, this means each dollar of credit can actually save you upwards of $1.50 in taxes.

Your provincial taxes are calculated as a percentage of your basic federal tax, so the less tax you owe Ottawa, the less you'll have to pay your province. Provincial tax rates range from 45 to 70 per cent of your federal tax bill. Tax credits are subtracted from your basic federal tax before assessing your federal surtax, making your credits worth even more.

Refundable and Non-Refundable Tax Credits

Refundable credits are always worth in real dollars what they're worth on paper. They're treated as if the money was actually paid to the government, just as when income tax is deducted from your pay check. If you didn't have to pay that money into the system, you get it back.

Non-refundable tax credits may be worth a lot less than the number you fill in on your tax return. This can happen if you have minimal income, or lots of deductions brining your federal tax down to a minimum if any at all. The most non-refundable tax credits can do for you is to eliminate federal tax and the associated provincial taxes and federal surtax.

What they can't do is get you a refund worth more than the tax you paid. Say you had a basic federal tax payable of $2,000, and you had $3,500 of non-refundable credits. Your tax payable will be zero, but you would not get a refund from the government for $1,500.

Sometimes, however, if you can't make use of a non-refundable tax credit, they can be transferred to other people in your family.

Attribution Rules

Income splitting is a strategy for decreasing the tax burden of a family.

How it works…..

Money or property is loaned or transferred to a lower-income family member so those gains are taxed at a lower rate. It can be a great way to minimize taxes but attribution rules can block many of these opportunities.

Attribution rules were designed to prevent attempts to shift income to another person by attributing it back to the person who transferred the money or property. In other words, if a higher income spouse transfers investments to a lower income spouse, any income realized on the investments could be assigned back to the higher income spouse.

In spite of the numerous attribution rules, some income-splitting opportunities do exist. For example, a higher income family member can pay all of the family's living expenses, leaving the lower income person with more to invest. Also, the child tax benefit may be invested in a child's name without any attribution of income back to the parents.

As in all matters related to tax planning, it's important to understand the rules and how they affect your specific situation.

Taxes and Your Investments

The only real number that matters to you when it comes to investing is what your after-tax rate of return is. Fixed-income investments paying 7% sounds good, but consider your after-tax return. If you were in the top tax bracket of around 50 per cent, you would only make 3.5%, which is quite a difference assuming the investment is outside of your RRSP.

The amount of tax paid on investments varies with the type of investment and how you have structured your portfolios. If you invest in side an RRSP or RRIF any income or gains are tax sheltered. However if you invest in a Non Registered account you are taxed in the year there is any income, capital gains or dividends earned.

The most heavily taxed investments are those that earn interest income such as GICs or CSBs. Stocks, real estate, and other investments that entail more risk but have the potential for higher returns in the form of capital gains are taxed at lower rates.

Minimize Taxes using RRSPs

Using your RRSP is the most effective way for you to save money for your retirement and the contributions are tax deductible.

Year-End Tax Planning

Here are some strategies you should be considering now before the end of the year.

1. Tax-Loss Selling

There are several ways to approach this strategy:

• transferring unrealized capital losses from a spouse or common-law partner
• Donate securities to a registered charity by year-end to receive a tax credit
• If you have investments with unrealized capital losses, you can sell them before year-end to realize the loss; then use the loss to offset realized capital gains in the current year.
• Or, you can offset any capital gains you may have incurred in the past three years, or carry the loss forward indefinitely to offset future capital gains.

2. Estate Planning

Is your will up to date? End-of-year financial house-keeping is a good time to review your will and make sure it represents your current situation and your intentions regarding your estate.

3. Registered Plans

If you have any unused contribution room in your RRSP, consider topping it up. If you turned 71 in the year, you only have until December 31 in that year to make a contribution to your RRSP.

4. Personal Payments

The final tax installment payment for 2010 is December 15th. Parents of children under 16 can claim a non-refundable tax credit of up to $500 for each child registered in an eligible physical activity program.

5. Mutual Fund Purchases

To avoid having to report year-end distributions, consider postponing the purchase of non-registered mutual funds until the New Year.

6. Non-deductible Interest on Your Loans

Consider paying off your debt by selling some of your non-registered investments, and then borrowing to replace the investment.

7. Allocating Pension Income to your Spouse

You may be able to increase your after-tax income from your retirement plans by allocating up to one-half of eligible income that qualifies for the existing pension income tax credit to your resident spouse or common-law partner.

Corporate Class Funds

If you are invested in traditional mutual funds outside your registered account, and want to sell units of a fund that have increased in value you will be subject to capital gains tax.

Traditional mutual funds are structured as a trust, and its tax efficiencies are advantageous to the fund company, rather than to you, the investor. Corporate class funds are set up as a corporation to invest in a group of mutual funds making it tax-efficient to the investor.

They defer any capital gains tax as long as you use the proceeds of a sale to buy into another class of the same fund company's corporate structure. Of course, taxes apply when the units of a corporate class fund are redeemed for cash.

Corporate class funds are ideal for investors who have maximized their RSPs and are looking for alternative ways to shelter portfolio gains.

When choosing a corporate class fund family, look for one with a wide variety of available funds. Ideally, it should include Canadian, U.S., global equity, sector and money market funds, as well as offering differing management styles.

Let’s take the first step!

T-Series Funds

Successful investing relies on many factors. T-Series Funds are mutual funds that are designed to be tax-efficient.

If you need a tax-efficient monthly income stream from your investments, without sacrificing the potential for capital gains, T-Series Funds could be for you. Designed for non-registered accounts, T-Series Funds are becoming increasingly popular. They are attractive to investors because they distribute return of capital (ROC), which is not immediately taxable.

When mutual funds make payouts in the form of interest, dividends or capital gains, they are taxed in the same year they are distributed. But the distributions from T-Series Funds are not taxed until your investment capital is depleted – in other words when the adjusted cost base (ACB) reaches zero – or until the units are sold.

This ability to defer taxes is one reason why T-Series Funds are considered tax-efficient. The other reason is that when the distributions are taxed, they are treated as capital gains, which are taxed at rates lower than interest income.

A fund that gives you control over when you incur a tax liability, allowing you to defer taxes, can be beneficial in several ways. You will benefit from higher after-tax income and the compounding effects of a larger investment. Plus, you may also be able to reduce the amount of tax you pay in the future, due to lower marginal tax rates or lower capital gains inclusion rates.

When considering T-Series Funds, look at payout rates, as they vary. Also look for T-Series Funds that make investment sense: Poor returns will result in smaller monthly distributions. Some funds are designed so that the ROC distribution takes up all or most of the expected return, enabling you to maintain your original investment in the fund.

As an added bonus, T-Series Funds that are part of a corporate class structure allow you to switch between asset classes without triggering a capital gain.

Finding the right investment vehicle for the right investor is part of the art of financial management. The flexibility and convenience of T-Series Funds could be ideal for you.

Let’s take the first step!

TFSA

The Tax-Free Savings Account was introduced in January 2009 by the Federal government as a new way to save money. Canadians are able to contribute up to $5,000 per year without being taxed on investment income or capital gains.

Here's how the Tax-Free Savings Account works:

• Contribute up to $5,000 per year tax-free
• You are not required to have earned income to contribute
• Withdraw money for any reason – without being taxed
• Choose from a variety of investment options: Mutual Funds, GICs and Savings Deposits
• You don't lose the contribution room if you make a withdrawal, but you do need to wait until the next year to re-contribute the money
• You can provide funds to your spouse for him or her to contribute to a Tax-Free Savings Account without being subjected to income attribution rules
• If you don't contribute the maximum amount, you can carry forward your unused contribution room indefinitely. For example, if you contribute $2,500 to your TFSA in 2009, your contribution room for 2010 will be $7,500 ($2,500 carried forward from 2009 plus $5,000 for 2010).

A NBF Advisor can help!

The Tax-Free Savings Account is a great new tax-sheltered account and, with the right advice, it can help you achieve your investment goals. But it all depends on your personal goals and situation. For example, if you've used your RRSP contribution room or cannot make RRSP contributions, the TFSA could be a solution for you. Another great investment planning opportunity is to potentially use your TFSA for income splitting with your spouse.

Let’s take the first step!