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Tax minimization strategies? ---- it depends .....

Tax minimization is not a simple or straightforward exercise: it depends on many diverse factors. While the government offers diverse ways to minimize tax payable the approaches are not equally effective or appropriate.


There are two types of employer and individual tax-assisted (tax tax-differ) pension approaches: Capital Accumulation Plans (CAPs) and Defined Benefit Plans (DB). Capital Accumulation Plans (CAPs) include Defined Contribution (DC), Pooled Registered Pension Plans (PRPPs), Registered Retirement Savings Plans (RRSPs,) and Tax Free Savings Accounts (TFSAs). CAPs fall under the Income Tax Act vs. federal or provincial pension legislation and CAPSA Guidelines. DB and DC plans are established and governed under federal and provincial pension legislation, as well as the Income Tax Act (ITA).


The ‘tax savings’ programs are actually taxed ‘deferral’ programs i.e., eventually, tax has to be paid. Any ‘tax savings’ result from the tax reduction (‘saving”) in a specific year vs. the tax that will have to be paid in the future. The underlying assumption is that your marginal tax rate in the future will be less than the current year hence the ‘tax saving.” However, it is not that simple – there are many things to consider. Various common tax-saving vehicles are discussed below.


An effective tax minimization strategy wills change with time and as circumstances change. Having a comprehensive up-to-date financial plan, with a strong tax component, is essential in selecting an effective approach.

Tax Free Savings Accounts (TFSA)


A TFSA allows you to contribute a prescribed amount annually. A TFSA is like a bank account – it is flexible, convenient, and the most effective and simplest way for most people to minimize tax.

Pro’s:

· earnings, gains, etc., for the year are not taxed

· Money can be withdrawn at any time without limit

· Withdrawals are not taxed

· Withdrawals can be put back into the TFSA in any following year

· The account can invest the money in a variety of investment vehicles

Con’s

· Contributions are not tax-deductible

· Not protected from creditors (unless the account is with an insurance company)

· Retirement income not guaranteed.

· Onus is on the account owner to invest the funds


Defined Contribution (DC), Pooled Registered Pension Plans (PPRPs)

DC plans and PRPPs are established by employers for employees. Both the employer and employee may make annual contributions (to a maximum set each year by CRA). DCs and PRPPs are convenient and flexible for both the employer and employee. The employer however has a fiduciary responsibility to the plan members which entails potential legal and financial risks (a known unknown). These types of accounts are an effective way to save for retirement and reduce taxes.

Pro's:

· Earnings, gains, etc., for the year are not taxed

· Employer contributions are taxable but offset by a deductible for employer and employee contributions

· Money in DC or PRPP may not be withdrawn unless allowed by the plan

· The contributions are automatic – a form of forced saving if employee contributions are required

· Protected from creditors

· The account can be invested in a variety of investment vehicles

· Onus and performance are on the account owner to invest the funds

· Portable – can be transferred to another employer, or financial institution, if you change jobs or when you retire

· The employer has a legal fiduciary role and responsibility to the plan members

Con’s

· Earnings, gains, etc., are 100% taxed when withdrawn (at the marginal tax rate)

· The savings are usually locked until retirement age

· Forced saving despite financial circumstances

· For the employer, the fiduciary role is onerous and entails possible legal and financial risks

· Retirement income not guaranteed.

· Onus is on the account owner to invest the funds effectively


Registered Retirement Savings Plans (RRSPs)

An RRSP can be set up by individuals or by employers for employees as part of their retirement

benefit program. The employer and employee may be required to make annual contributions (to a maximum set each year by CRA). The employer however has a fiduciary responsibility to the plan members which entails potential legal and financial risks (a known unknown. RRSPs are convenient and flexible for both the employer and employee but may not be the best option to minimize tax over time.


In the case of solvency, an RRSP could be exposed to a creditor if a court order is obtained. This depends on each province’s rules for non-bankruptcy and circumstances.


Bankruptcy protection, at the federal level, is provided for RRSPs, RRIFs, RDSPs, and deferred profit-sharing plans (DPSPs). For provinces and territories without creditor protection, federal legislation protects registered plans from creditors if the annuitant declares bankruptcy.


Bankruptcy protection usually does not apply to contributions made within 12 months of declaring bankruptcy or, within 5 years if insolvent. Bankruptcy law also considers contributions made in the previous five-year period if the annuitant or account holder was bankrupt or anticipated declaring bankruptcy. (Creditor protection does not apply if the creditor is CRA.)

Pro’s:

· Earnings, gains, etc. for the year are not taxed.

· Employer contributions are taxable but offset by a deductible for the employer and

employee contributions

· Money in RRSP in an employer program may not be withdrawn unless allowed by the plan

· The contributions to an employer RRSP are automatic – a form of forced saving

· Protected from creditors in many cases

· Portable – can be transferred to another employer or service provider if you change jobs

· The employer has a legal fiduciary role and responsibility to the plan members

· The account can be invested in a variety of investment vehicles

Con’s

· Earnings, gains, etc., are 100% taxed when withdrawn (at the marginal tax -usually higher)

· The saving in an employer RRSP may be locked until retirement age

· Forced saving despite the financial circumstances of an employer RRSP

· For the employer, the fiduciary role is onerous and entails possible legal and financial risks

· An RRSP must be converted to an RRIF at the age 72

· RRIF withdrawal rules apply

· Retirement income not guaranteed.

· Onus is on the account owner to invest the funds effectively.


RRIFs. LIRAs, and LIFs

RRIFs, RRIFs, LIRAs, LIFs, etc., are similar in most respects to an RRSP. They are held as separate accounts through a financial institution bank. In some cases, a sponsor may allow employees who retire or terminate to remain in the pension programs, however, this results in additional, and not insignificant financial and legal risks and, administration costs for the sponsor. RRIFs LIRAs and LIFs are ‘locked into’ specific rules and requirements under the ITA.


Pro’s:

· Earnings, gains et,c, or the in the year are not taxed

· Employer contributions are taxable but offset by a deductible for employer and employee contributions

· Money in RIFF, LIRA, LIF in an employer program may not be withdrawn unless allowed by the plan

· The account can be invested the money in a variety of investment vehicles

· Protected from creditors

· Portable – can be transferred to another employer or a service provider if you change j jobs

· The employer has a legal fiduciary role and responsibility to the plan members

Con’s

· Contributions are not allowed except for transfers from a DC, PRPP, or another RRIF are generally higher)

· The saving in an employer RRSP may be locked until retirement age

Contributions are not allowed except for transfers from a DC, PRPP, or another RRIF Minimum annual withdrawals are required at age 72 (withdrawal rate is set by CRA)

· Forced saving despite financial circumstances in an employer RRSP

· The sponsor’s fiduciary responsibilities are onerous and entail possible legal and financial risks, and costs.

· Retirement income not guaranteed.

· Onus is on the account owner to invest the funds


Principal Residence

A principal residence is traditionally considered a good way to increase net worth (savings) while avoiding tax on any gain, and you need a place to live. If you sell, however, you may be forced to buy so the ‘net’ wealth outcome can be in question there are also costs, often overlooked, that reduce the actual gain.

Pro’s:

· Any gain, if the house is sold, is not taxed.

· The principal residence often appreciates in value.

· There is no requirement to sell

· Money can be borrowed, using the house as collateral, and invested.

Con’s

· There are costs involved in maintaining or renovating a principal residence

· Location and market timing are potential risks – known unknowns

· Continuing to own a house may result in a person being asset rich and cash poor

· Losses on the sale of a principal residence are not tax-deductible


Regular (Non-registered) Account – Investment Strategies

The earnings and gains made in a regular (non-registered – non-pension type accounts) are taxed each year, at the current tax rates. The advantages of having investments in a non-registered account are significant and can result in the total tax paid, over a lifetime, is minimized. The advantages of having investments in a non-registered account are often overlooked when there is a focus and enthusiasm to minimizing current (short-term) tax payable.


There are three types of security type investments available in savings accounts: 1) dividends, 2) capital Gains, and 3) interest income. Each of the investments is treated differently for tax purposes and which may result in a lower effective tax rate. Bear in mind that all withdrawals from registered accounts (pension accounts) are 100% taxable at your marginal tax rate.


1) Capital Gains – The sale of shares, bonds, options, and other financial vehicles, real property, personal property, rights, etc., during the year, will usually result in a capital gain or loss and must be reported for tax purposes. These disposals receive special tax treatment resulting in lower tax payable. Capital gains are an effective way to minimize tax in non-registered investment accounts or avoid tax in a TFSA.


The taxable amount is only 50% of the selling price less the cost (the Adjusted Cost Base - ACB) and is included in income and taxed at the marginal income tax rate. If a loss is realized from the disposition, it can only be deducted against capital gains of the current year, the past 3 years, or it can be carried forward and deducted against capital gains of a future year. Some capital type investments are only redeemable or sold at cost e.g., shares of certain mortgage companies, hence there is no capital gain or loss.


If there are frequent dispositions of an ‘investment’ CRA may deem these transactions to be income vs. capital gains and include them in taxable income. The intent when acquiring an ‘investment’ is important and must be supportable.

Investing for capital gains is an effective way to minimize tax. It is commonly used in non-registered accounts or for ‘personal’ property and investment etc. not held in registered (pension type) accounts. However, gains or income of any type (capital gains, dividends Interest income) in a non-registered account is taxed as income when withdrawn from the account and taxed at your marginal tax rate.

2) Dividends – are received from investments of shares in certain companies. Dividends are taxed in the year received but receive special tax treatment. In Canada, the dividend amount received from a Canadian publicly-traded company is grossed up by 138% and included in taxable income. However, an offsetting, non-refundable tax credit of 15.02% of the grossed-up amount is calculated and used to reduce tax payable. The net effect is that dividends are taxed at a lower rate than regular income i.e., at a rate similar to capital gains. Dividends are an effective investment strategy to minimize tax in non-registered investment accounts and avoid tax via a TFSA.


Investing for the purpose of earning dividends is a common strategy to generate retirement income in registered (pension type) accounts. However, dividends in a registered account are treated as taxable come when withdrawn from a registered account and taxed at your marginal tax rate i.e., the only tax advantage in having dividend income in a registered account is the potential delay (the year the income is withdrawn) to pay tax.


3) Interest Income – is earned on investments in bonds, GICs, Notes, mortgages, mortgage investment corporations, bank accounts, etc., All interest, from any source and or type of account, is included in income, in the year received, or when withdrawn from a registered account, and at the marginal tax rate. Interest on bonds, GICs, and other types of investments must be included in income in non-registered accounts on an accrual basis vs. when received. There are exceptions: interest on compound interest bonds, GICs, etc., however, is not taxed until redeemed or sold e.g., Canada saving bonds, GICs, provincial bonds, municipal bonds, etc.


Interest rates on government bonds, GICs, and bank accounts tend to be lower than the income from other investments. Investors often choose certain interest-type investments for safety and/or regularity and frequency of payments.


Having interest-type securities in a TFSA account avoids tax and provides investment ‘security.’ Otherwise, it is not an effective way to minimize tax.


Defined Benefit Plans (DBs) – in some cases - forced saving

Some employers offer DB plans as part of their remuneration and benefits programs. The contribution and the benefits can be in the form of a flat benefit (usually union) plan, or a salary-based (non-union plans). The employer deducts contributions in the year paid. The employee does not pay tax on contributions: the employee only pays tax when pension payments are received.


In some cases, an employee is required to contribute to the DB plan: these contributions are tax deductible-type of forced saving, However, it may not be an optimal investment strategy for the funds contributed.

While DB plans provide a guaranteed level of retirement for an employee, and usually their spouse, they are not risk-free. DB plans must always be adequately funded in order to be able to pay benefits. If the employer becomes bankrupt or cannot fully fund the DB plan the benefits will be reduced.

An Individual Pension Plan (IPP) is available to small business owners and professionals. It is similar to a B+DB and offers DB benefits and other advantages to the beneficiaries.


DB sponsors usually offer Capital Accumulation Plans as part of the benefits to provide a way for employees to augment their retirement income. In doing this, the sponsor takes on additional financial and legal risk and administrative costs.


Summary

Selecting an effective tax minimization strategy is not a simple or straightforward exercise. The approach is unique for each individual and requires a clear understanding of retirement objectives, investments, investing, and tax law. The only efficient and effective way to minimize tax is with a formal, comprehensive financial (retirement) plan that has a strong tax component, and an experienced advisor.




G. Wahl, Managing Director, PensionAssistant

604-985-0996

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