Knowing how tax rules affect your investments is essential to maximizing your after-tax return. In addition, keeping up to date on changes to the tax rules ensures that you take advantage of all the tax savings available to Canadian-resident individuals. This article provides an overview of select strategies to assist you in reducing your 2023 tax bill.
Reduce tax with income-splitting
Under our tax system, the more you earn, the more you pay in income taxes on incremental dollars earned. With this in mind, it makes sense to spread income among family members who are taxed at lower marginal rates in order to lower your family’s overall tax burden, subject to the income attribution rules. Some of the more common income-splitting strategies you may want to discuss with your tax advisor include1:
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Pension income-splitting between spouses (or common-law partners);
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Gifts to adult children or other adult family members (other than a spouse or common-law partner); and
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Gifts to a minor child – directly or through a trust structure – to acquire investments that generate only capital gains.
A popular income-splitting strategy during a low-interest rate environment is a prescribed interest rate loan to a family member in a lower tax bracket. However, as the prescribed rate has been increasing, the income-splitting benefit of this strategy has narrowed considerably. As such, the strategy may no longer be beneficial for most taxpayers, unless sufficient funds are advanced and there is a significant discrepancy in marginal rates between family members (depending on the amount and nature of investment income earned on the loaned funds relative to the applicable prescribed interest rate on the loan).
Make your portfolio tax-efficient
In evaluating investments for your portfolio, you should consider the impact of income taxes, since not all investment income is taxed in the same manner. Despite the wide range of investments available, there are three basic types of investment income: interest, capital gains and dividends. Interest income is fully taxable at your marginal tax rate, whereas you only pay tax on 50 per cent of a capital gain. Canadian dividends also receive special tax treatment through the Federal and provincial dividend grossup and tax credit mechanisms.
Maximize your tax deferred savings with an RRSP or TFSA
In evaluating investments for your portfolio, you should consider the impact of income taxes, since not all investment income is taxed in the same manner.
Despite the wide range of investments available, there are three basic types of investment income: interest, capital gains and dividends. Interest income is fully taxable at your marginal tax rate, whereas you only pay tax on 50 per cent of a capital gain. Canadian dividends also receive special tax treatment through the Federal and provincial dividend grossup and tax credit mechanisms.
Maximize your tax deferred savings with an RRSP, TFSA, or tax-free First Home Savings Account (“FHSA”)
Your Registered Retirement Savings Plan (“RRSP”) is likely the cornerstone of your overall retirement strategy. Allowable contributions to your RRSP are tax deductible and the income earned in an RRSP is not taxed until it is withdrawn. This means that your savings will grow faster in an RRSP than they would if held outside an RRSP. Some ideas to optimize your RRSP savings include maximizing your annual contribution limit, contributing securities “in-kind,” deferring the maturity of your RRSP until age 71, and contributing to a Spousal RRSP if you and your spouse/common-law partner will have disproportionate retirement income levels.
The Tax-Free Savings Account (“TFSA”), introduced in 2009, is a general purpose, tax-efficient savings vehicle that allows individuals, 18 years of age or older, to contribute annually (now up to $6,500 in 2023) to this registered account, where both income earned within the plan and withdrawals are tax-free.
A TFSA is beneficial for many investors and for many different reasons, including saving for short-term purchases, such as an automobile, or saving for longer-term goals such as a child’s education or retirement. TFSAs can also be an effective income-splitting tool. A higher income spouse can give funds to the lower income spouse or an adult child so that they can contribute to their own TFSA (subject to their personal TFSA contribution limits), since the attribution rules will not apply to income earned within the spouse’s (or adult child’s) TFSA.
Because of its flexibility, a TFSA complements other existing registered savings plans for retirement and education. As a result, the TFSA has quickly become an important investment vehicle for many Canadians.
The 2022 Federal Budget proposed the introduction of the tax-free First Home Savings Account (“FHSA”), which is expected to be available sometime in 2023. This new registered account will provide first-time home buyers the ability to save up to $40,000 towards the purchase of a first home. Combining hallmark attributes of RRSPs and TFSAs, contributions made into the FHSA would be tax-deductible and income earned in an FHSA would not be subject to tax. Qualifying withdrawals (including investment income) from the FHSA to purchase a first home would be non-taxable. First-time homeowners (at least 18 years of age) eligible to open an FHSA, will be subject to an annual contribution limit of $8,000, with a lifetime limit of $40,000.
For more information and some planning considerations regarding this new registered plan, please ask your BMO financial professional for a copy of our publication, First Home Savings Account.
Use an RESP to save for children’s education needs
The increasing cost of post-secondary education is causing many parents to be concerned about funding their child’s education. The benefits of the Canada Education Savings Grant (“CESG”), combined with the advantages of an Registered Education Savings Plan (“RESP”), make RESPs a very attractive vehicle to fund your children’s or grandchildren’s education. Contributions to an RESP are not tax deductible. However, the income from investments in an RESP is tax sheltered as long as it remains in the plan. Withdrawals to pay education expenses from accumulated income and the CESG will be taxable in the beneficiary’s hands at his/her marginal tax rate.
Use an RDSP to save for the financial needs of a disabled child
The Registered Disability Savings Plan (“RSDP”) is a registered savings plan intended to help parents and others save for the long-term financial security of persons with severe or prolonged disabilities who are eligible for the Disability Tax Credit. Contributions, up to a lifetime maximum of $200,000 per beneficiary, can be made to an RDSP until the end of the year in which the disabled beneficiary turns 59, with no annual limit. Contributions are not tax deductible; however, any investment earnings that accrue within the plan grow on a tax deferred basis.
In addition, Canada Disability Savings Bonds (“CDSB”) and Canada Disability Savings Grants (“CDSG”), up to annual and lifetime limits, can be received in an RDSP from the Federal government depending on family income.
Donate appreciated securities
The benefits of making a charitable donation are countless, from helping those in need to the personal satisfaction we feel when giving something back to a cause we feel passionate about. With proper planning, you can also reduce your income tax liability and maximize the value of your donation. A donation of publicly-traded securities may be preferred over a cash donation of equal value, particularly in cases where you have already decided to dispose of the securities during the year. A charitable tax receipt equal to the fair market value of securities donated to charity will reduce your taxes through a donation tax credit. Donations over $200 made from income subject to the top Federal marginal rate can result in tax savings approximating 50 per cent of the value of the donation (depending on your province of residence).
A donation of securities is considered a disposition for tax purposes. However, because of the tax incentives on a donation of qualifying, appreciated publicly-traded securities to charity, the capital gain inclusion rate is nil instead of the normal 50 per cent that would otherwise apply.
Use borrowed funds to invest
Generally, interest expenses are deductible for tax purposes if the funds are borrowed for the purpose of earning income from a business or an investment vehicle. Therefore, consider paying down non-deductible personal debts (such as RRSP loans, mortgages on home purchases and credit card balances) before paying down tax-deductible, investment-related debt. For more information, ask your BMO financial professional for a copy of our publication, Leveraged Investment Strategies and Interest Deductibility, and speak with your tax advisor about structuring your borrowing to achieve tax deductibility.
Reduce tax for your estate
Your estate plan can accommodate a number of tax saving strategies which may help to reduce or defer the amount of tax payable by your estate and help maximize the amount available to your heirs. Some of the most common planning strategies include establishing a trust in your Will to split investment income with low income beneficiaries, naming an appropriate beneficiary for your RRSP/RRIF or TFSA, making charitable bequests in your Will, and bequesting appreciated assets to your spouse/commonlaw partner (or a qualifying spousal trust) with a view to deferring tax on the accrued capital gains2.
Consider U.S. estate tax implications if you own U.S. investments.
U.S. estate tax can apply to Canadian residents on the value of U.S. assets owned at death, even if they are not U.S. citizens or Green Card holders. A Canadian may have a U.S. estate tax liability if the value of their U.S. assets exceed US$60,000. For 2023, the threshold level of worldwide estate assets held at death at which Canadians are exposed to U.S. estate tax is US$12,920,000. The U.S. estate tax rates range from 18 per cent to 40 per cent.
Although any potential U.S. estate tax liability may be reduced or offset by credits and deductions available under Canadian and U.S. tax law, and the Canada-U.S. Tax Convention (the “Treaty”), a U.S. estate tax return may still need to be filed even if there is no ultimate U.S. estate tax liability. Failure to file a U.S. estate tax return can result in a denial of treaty benefits and credits. In addition, an estate, beneficiary or surviving joint owner may not be able to sell U.S. real property without proof that a U.S. estate tax return has been filed and the tax owing, if any, has been paid.
Seek advice
Please note that this article should not be construed as tax advice and individuals should consult with a tax advisor regarding their personal situation.
For more information, please speak with your BMO financial professional.
1On a related note, be aware that the tax legislation seeks to limit income-splitting with certain adult family members involving private companies, effective for the 2018 and subsequent taxation years. For more information, please ask your BMO financial professional for a copy of our publication, "Tax Changes Affecting Private Corporations: Tax on Split Income ("TSOI")".
2Quebec does not allow the ability to name a direct beneficiary for an RRSP, RRIF or TFSA in the contract itself, instead a beneficiary can only be appointed in a Will.
BMO Private Wealth provides this publication for informational purposes only and it is not and should not be construed as professional advice to any individual. The information contained in this publication is based on material believed to be reliable at the time of publication, but BMO Private Wealth cannot guarantee the information is accurate or complete. Individuals should contact their BMO representative for professional advice regarding their personal circumstances and/or financial position. The comments included in this publication are not intended to be a definitive analysis of tax applicability or trust and estates law. The comments are general in nature and professional advice regarding an individual’s particular tax position should be obtained in respect of any person’s specific circumstances.
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