Tax-efficient investment strategies can enhance your after-tax income and increase the overall rate of return on your portfolio. Tax efficient investing comprises a number of key components including income splitting and income rebalancing.
Income splitting strategies shift investment income and capital gains from being taxed in your hands, at a higher marginal tax rate, to the hands of your lower-income family members to reduce your family’s overall tax bill. If a family member has no other income, they could earn up to $10,000 of interest income, $20,000 of capital gains or $30,000-$50,000 of Canadian dividends tax-free annually through income splitting (note that the amount varies by province).
Expense Funding Strategy
Tax efficient investing and overall tax savings for your family can be accomplished by having investment income taxed in the lower-income spouse’s hands.
By having the higher-income spouse pay all the family expenses, it allows the lower-income spouse to save their earnings and invest them. The resulting investment income can then be taxed at the lower-income spouse’s tax rate.
Consider lending money to a lower-income spouse at the Canada Revenue Agency’s (CRA) current prescribed rate of one per cent in order to take advantage of that spouse’s lower marginal tax rate on future investment income. Your spouse must make the annual interest payment owed to you on the spousal loan by Jan. 30 of the following year, otherwise, any income and capital gains earned on the borrowed funds will be attributed back to you for that particular year and every subsequent year that the loan is in place.
While you will have to report the interest income from your spouse, your spouse will be entitled to a tax deduction for that interest payment and be able to claim the investment income generated, which will be taxed at their lower rate. This strategy may result in overall annual tax savings for your family, with even larger tax savings at retirement arising from years of accumulation of capital in the lower-income spouse’s hands.
Family Trust Loan
Consider using a family trust to lend funds at the prescribed rate to other family members such as children or grandchildren, who are in lower tax brackets. The trust would invest
the proceeds of the loan at a rate of return that is sufficient to cover at least the interest on the loan. The net income earned (after deducting the interest expense paid to you) will be taxed in the hands of your children or grandchildren at their lower marginal tax rates.
It is important to discuss this option with your legal advisor prior to implementing this strategy.
Since the income earned within a TFSA is not taxable, if you gift money to your spouse or adult child to contribute to their TFSA, the income and growth in the account will not be attributed back to you.
Unlike conventional income splitting strategies that consider the source of the invested funds, this TFSA account allows you, your spouse and/or adult child to earn tax-free investment income, regardless of whose money is invested. Keep in mind that although gifting assets allows you to split income, the assets you gift are no longer yours and become the property of the receiver.
It is important to recognize that different types of investment income are taxed differently in non-registered accounts. For example, capital gains and Canadian dividends are taxed at more favourable rates than interest income and foreign income. Canadian dividends are effectively taxed at a lower rate than interest income due to the dividend tax credit that is applied to the federal and provincial taxes payable.
The use of a tax credit is meant to recognize that the Canadian corporation paying the dividends has already paid tax on its earnings, which are now being distributed to investors. Capital gains are also taxed at a lower rate considering only 50 per cent of net capital gains are included in your income. On the other hand, interest and foreign income (including dividends from foreign corporations) are fully taxable at your marginal tax rate.
As such, from a tax perspective, consider rebalancing the mix of assets in your portfolio to focus on holding equity investments outside your registered accounts to benefit from the preferred tax treatment of capital gains and dividends.
Also, since the income generated from your investments is not taxed in your registered accounts, where possible, consider holding fixed income investments inside your registered plan to defer tax on the interest income.
This article is supplied by Kirbey Lockhart, an investment advisor with RBC Dominion Securities. Member CIPF. This article is for information purposes only. Please consult with a professional advisor before taking any action based on information in this article.