Many people resolve to do their tax planning during the last few months of the year. However, to effectively reduce your current or future tax liability, planning should be a year round endeavor.

Income Splitting

Income splitting is a great tactic to save tax. It involves structuring your affairs to move income to the hands of a lower-income family member who will pay less tax.

Spousal RRSP

One of the few remaining income splitting opportunities is a spousal RRSP. The primary reason for establishing a spousal RRSP is to allow for income splitting at retirement. Because the assets are considered the property of your spouse, when the funds are withdrawn from the plan, they are taxed at the spouse’s lower (hopefully) marginal tax rate.

Spousal Loan

The purpose of a spousal loan is to legally shift income from one spouse to the other. Under normal circumstances, a spouse cannot arbitrarily direct funds into the hands of the other spouse. However no rule or piece of legislation exists to prevent a loan from being made. Once the loan is made, the lower income spouse can then take the funds and invest them in his or her own name without the income attributing back to the higher income spouse. Attribution is avoided because the spouse loaning the funds will do so at CRA’s prescribed rate of interest (set at 3% for January - March 2003).

Once the loan is set up, it can remain in place forever. If we assume that the lower income spouse will be able to get more than 3% on the borrowed funds, then the higher income spouse will have effectively shifted income and therefore saved some tax. The savings realized will of course depend on the amount of funds loaned as well as the amount of the yield earned above the prescribed rate. To ensure this tax planning strategy is kept valid, the lower income spouse must ensure that the interest owed on the loan is paid by January 30th of the following year.

For those who have this strategy already in place, remember to pay the interest on these loans no later than Jan. 30, 2003, for interest levied in 2002. And don’t forget that the interest is deductible to the spouse paying the interest and taxable to the lending spouse.

Income on Income

As mentioned above, the attribution rules tax income earned on money transferred to a spouse back to the transferring spouse. This income however, is then the capital of the spouse receiving it for reinvestment purposes. The income earned on this reinvested capital (income on income) is not attributed back but is instead taxed in the hands of the transferring spouse.

Keep in mind that the income on the original capital transferred will continue to be taxed each year in the hands of the transferring spouse. Over time this strategy is a very effective method of transferring capital from a spouse in a high tax bracket to a spouse in lower tax bracket. This type of arrangement requires that you maintain two accounts so that attributed and non-attributed income is easily separated.

Charitable Donations of Publicly Traded Securities

The advantages of charitable gifting from a tax consideration have grown. The 1997 Federal Budget introduced a provision to encourage the gift of marketable securities to charitable organizations. When you donate stocks, bonds, or other publicly traded securities, including mutual funds, to a charity, you’ll be deemed to have sold those investments at fair market value. This could trigger a tax hit. However, any capital gains on the donation of publicly traded securities are eligible for a reduced capital gains inclusion rate of 25% instead of 50%.

April is tax time

Effective tax rates will be a little lower in 2003 mostly due to indexing of tax brackets and credits to inflation. For 2003, the lowest tax bracket ends at $32,183 and the highest tax bracket for 2003 kicks in at $104,648. Every individual gets a basic federal credit, which allows you to receive a basic amount of income on a tax-free basis. For 2003, the basic amount is $7,756 up from $7,634 in 2002.

One of the benefits of self-employment are the tax breaks available. You are entitled to a deduction for any costs incurred for the purpose of earning income from your business, as long as the cost is reasonable in amount. In addition, self-employment can open the door to income-splitting opportunities, where you pay a salary to a spouse or kids who are able and willing to work in the business.

Creating Deductible Debt

From a tax planning perspective deductible debt is preferable to non-deductible debt. Being able to deduct the interest costs of borrowed money will reduce the amount of income that must be reported and therefore the amount of tax that must be paid. It is for this reason that financial advisors will try to encourage their clients to switch their non-deductible debt for deductible debt.

One such strategy might be to convert all, or part of your mortgage debt into an investment or business loan. For example, if you have a $125,000 mortgage and a $125,000 investment portfolio, sell the portfolio and use the funds to pay off the mortgage. Immediately borrow the funds again and repurchase the portfolio. This way the interest incurred on the investment portfolio is tax deductible. (the interest on the mortgage was not).

Deferring a Capital Gain

It is possible to spread the tax bill on a taxable capital gain over a period of five years by claiming the ‘capital gains reserve.’ If a capital asset is sold ( to a child, a spouse or common-law partner, a corporation of either a child, spouse or CLP) at a profit and the full amount of the proceeds are not received by the end of the year, a part of the capital gain may be deferred by claiming a reserve for the proceeds not yet received. Under the reserve rules, you must bring into income at least 1/5 of the gain each year (cumulatively), so that the entire capital is accounted for by the fourth year after the year of sale. Keep in mind that a reserve might not be beneficial where you may be in a higher tax bracket in later years. To ensure this strategy is right for you, consult your tax advisor.

Registered Retirement Savings Plan

For those without access to an employer sponsored pension plan, the cornerstone of any good tax plan will be the registered retirement savings plan. The RRSP is one of the few good tax shelters left.

You have until March 1, 2003, to make a contribution to your RRSP that will entitle you to a deduction on your 2002 tax return. Make that contribution sooner rather than later to get that money working for you as soon as possible. And don’t wait until January or February of 2004 to make your 2003 RRSP contribution. By contributing now you will benefit from the immediate tax-free compounding.

If you do not have the lump sum funds to make the contribution now consider making monthly contributions. If possible RRSP contributions should be made from periodic payrolls on a pre-tax basis as you will receive the benefit of the tax refund immediately. In a volatile market these strategies can add the benefit of dollar-cost averaging which minimizes risk by spreading investments over time. When the market is down, the RRSP can buy more units, which means that when it goes back up, the portfolio is worth more.

If you have significant unused RRSP contribution room, and you’re behind in saving for retirement, it could make sense to take out an RRSP catch-up loan to use up that contribution room. However, this strategy only makes sense if the loan will be paid back in a relatively short time frame (1 year).

Education Savings

A four-year university education in Canada will cost at a minimum approximately $32,000 and that does not include the cost of books and transportation. In 18 years and at a five percent average annual increase in fees, it will cost close to $77,000. With the current trend of rising tuition fees parents have actually started putting money aside for post-secondary education. A Registered Education Savings Plan (RESP) is a tax-deferred plan. Although contributions to an RESP are not tax deductible, all income earned in the plan compounds tax-free until it is withdrawn by the student. At that time, the student will likely pay little, if any tax based on their lower tax bracket.

An additional benefit of the RESP is the Canada Education Savings Grant (CESG) program. It provides a grant of 20% on the first $2,000 of annual contributions made in a year to an RESP, giving you an extra 20% return on your first $2,000 of contributions each year per beneficiary.

As an alternative to an RESP, you could invest in tax-efficient growth mutual funds in your child’s name. Until your child turns 18, the dividends and interest will be taxed in your hands due to the attribution rules however any capital gains distributed by the fund will be taxed in your child’s hands at their lower tax rate. Assuming the fund selected is a tax-efficient mutual fund the amount reported on your tax return will be a small proportion of the fund’s overall return.

Conclusion

Tax planning means that you are entitled to arrange your affairs, within the limits of law, so that you pay a minimum amount of tax. And if done throughout the year will save the most money at tax time.

To contact Lynn Lewis, visit her personal profile page at this link