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Canadians who earn more than $200,000 per year face personal income tax rates upwards of 50 percent. However, prior to the 2018 federal budget, high earning individuals enjoyed two effective strategies to reduce their overall tax burden – income splitting and reinvesting undistributed earnings from an active business into a private corporation.
New legislation now challenges high earning Canadians by either eliminating or significantly reducing the benefits of these two tax planning strategies and Canadians are justifiably concerned about what that means for their bottom line.
High earning Canadians now need to look at other potential options to help offset the increased costs. We look at several below.
While income splitting between family members may no longer be viable, the new rules do not prevent higher income spouses from lending money to a spouse, child or family trust for investment purposes. Through a prescribed rate loan, the recipient has the potential to earn investment income with the borrowed funds.
Importantly, achieving the benefit of a prescribed rate loan requires meeting several key criteria. First, to avoid attribution rules (i.e. to receive the tax benefit), the higher income family member must provide this loan at a prescribed interest rate set by the Canada Revenue Agency – currently two percent. Moreover, they must also declare the interest income they earn from the loan on their annual tax return. Finally, interest on the loan must be paid annually by January 30 for the prior year’s interest.
The tax-free savings account (TFSA) continues to be a critical tool for Canadians to manage their wealth and investments. But it also remains one of the most misunderstood. Although a TFSA does not shelter employment income from taxes, it does provide a useful vehicle for after-tax income to grow. And there are several effective ways to use it.
The first (and least efficient) is as a regular savings account. Canadian taxpayers may contribute up to $5,500 annually and interest paid on those savings will grow tax-free. However, individuals may also use the account to purchase investment vehicles such as stocks, mutual funds, exchange traded funds, GICs and bonds. Whatever profits they earn on those investments will also grow tax free.
The federal government has committed to increasing the annual contribution at the rate of inflation (rounded to the nearest $500), and any unused contribution room automatically carries forward to subsequent years. Therefore, anyone who has not leveraged their TFSA to its full potential can still catch up.
The Spousal RRSP is an effective way to equalize retirement income between spouses while at the same time decreasing the family’s immediate and long-term tax burden. A higher-income spouse may use their unused RRSP contribution room in a given tax year to deposit money into their lower-income spouse’s RRSP. The contributing spouse may deduct that amount from their own taxable income. In turn, the receiving spouse will pay income tax on those contributions when they begin withdrawing funds post-retirement. Note, if a withdrawal is made within three years of a contribution, the income from the withdrawal will be attributed back to the contributing spouse for income tax purposes.
Because both spouses will have RRSP savings to draw from, both can withdraw a lower annual amount from their RRSP when they retire. This reduces the total percentage of tax the higher-income earning spouse would need to pay to maintain their desired standard of living.
Flow-through shares are an incentive program from the Canadian government meant to encourage taxpayer investment in resource exploration and development businesses. Like common shares, flow-through shares offer investors an equity stake in an organization. Where they differ is in their allowance for resource companies to flow their expenses through to their investors via the share purchase price. In return, investors may deduct these expenses, up to the original investment value, from their taxable income – thus providing the company with needed working capital while offering significant tax benefits to the shareholder.
Like all investments, flow-through shares carry a certain level of risk. The company may fail to realize their exploration and development goals, the share value may drop or the business itself may fold. Canadians considering flow-through shares will want to consider their risk tolerance when deciding whether flow-through shares are right for them.
Tax-exempt life insurance offers another means of providing tax-free wealth to family members in an environment where income-splitting is no longer viable. Unlike term life insurance, tax-exempt life insurance allows for investing for growth within the life insurance policy, similar to an RSP or pension, which means it will grow over time beyond regular contributions.
High-income earners deposit a portion of their after-tax income toward their policy, which then grows tax-free for the duration of the policy. Upon the policyholder’s death, the beneficiaries will not pay any income or estate tax on the disbursement – therefore receiving the full value of the fund, including all interest, dividends and market growth earned.
For more information on how MNP can help, contact Steven Smith, CPA, CA, Senior Manager, Private Client Services, at 647.775.1729 or [email protected]
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