Tips to minimize taxes before – and during – retirement
Strategies like income-splitting and tax-loss selling can help reduce your client’s tax bill, but planning ahead is crucial
By: TERRY CAIN
Date: November 15, 2016
No one likes paying more tax than they need to. When it comes to retirement planning, it can be challenging to effectively minimize a client’s tax burden. But there are some key techniques and strategies advisors can use to make sure their retirement nest egg isn’t unnecessarily eroded by taxes.
The first thing to bear in mind is the importance of taking a longer-term vision for managing tax, rather than simply minimizing the current year’s taxes, says Cheryl Norton, director of advanced planning, wealth distribution, at Sun Life Financial.
“Tax planning should be done consistently and reviewed at least on an annual basis,” says Ms. Norton. “Most of our government benefits in Canada are income-tested, so if you can plan tax efficiently for retirement, you can maximize your overall retirement income.”
Jason Pereira is a senior financial consultant with Woodgate Financial & IPC Investment Corporation in Toronto, and he notes that the importance of tax planning depends heavily on an individual’s total wealth and tax bracket. Mr. Pereira says that for Canadians earning low to average income, using their registered retirement savings plans (RRSPs) and tax-free savings accounts (TFSAs) will likely mean most (if not all) of their assets will be tax-sheltered investments. However, he notes that this changes at retirement, and managing RRSP/RRIF (registered retirement income fund) withdrawals becomes very important from a tax-planning standpoint.
For wealthier Canadians, managing investments and drawing on them in a tax-efficient manner is of “enormous importance,” notes Mr. Pereira. He says that with several years of increasing tax rates – and with many provinces now having top marginal rates above 50 per cent – Canadians who are not working to manage their tax bill in retirement are only making it harder to ensure that their retirement is secure.
A good place to start is with RRSPs and TFSAs, says Ms. Norton. "RRSPs are definitely beneficial, especially for clients who are earning income in the top tax bracket," she says. "TFSAs are a great tool as well that cannot be overlooked."
Mutual funds as well as corporate class mutual funds have the ability to pay an income stream that is considered “return of capital” in non-registered accounts. Return of capital is not taxable in the year received, however does decrease the adjusted cost base of the portfolio. In a non-registered investment this has the effect of deferring capital gains to a future date. Ms. Norton notes that annuities and segregated fund contracts with guaranteed income also have the benefit of offering a return of capital portion. Capital gains are currently only 50% taxable in Canada, which is preferential to interest income.
Another important consideration is asset location. It makes sense to hold assets that are more highly taxed in sheltered accounts rather than taxable accounts. Here’s an example of one strategy that can be used: bonds can be primarily allocated to RRSPs and TFSAs because interest is fully taxable. When it comes to stocks, if there is RRSP or TFSA contribution room left after all your bonds are purchased, consider foreign stocks that pay dividends as your next priority. Then, consider Canadian dividend-paying stocks and lastly, non-dividend-paying stocks.
“The idea is to shelter as much taxable income as possible, and pay preferential tax (such as capital gains) on assets held in non-registered accounts,” says Mr. Pereira.
A basic technique that should not be overlooked is tax-loss selling. If an investment you hold has lost value at the end of the year, from a tax perspective, selling it may be a good idea. The loss can be used to reduce your capital gains on other investments. It can also be carried back up to three years or carried forward indefinitely.
A possibility for some people may be incorporation. For those eligible to incorporate, their personal business can be a great tax deferral vehicle. Keeping in mind that rates differ per province, the small business tax rate on the first $500,000 of pre-tax earnings is 15 per cent for active business income, while the top personal tax rate is over 53 per cent.
As individuals move toward their retirement years, several other tax-saving methods arise. A major one is income splitting, says Ms. Norton.
“Maximizing your income splitting opportunities with your spouse will help ensure that your family keeps more money,” she says.
Income splitting can be used in several situations, including:
- CPP (Canada Pension Plan) – As long as both spouses are 60 or older at the time of application, you can file to share your CPP income, which may result in tax savings.
- Pensions and RRIFs (registered retirement income funds) – Eligible pension income and RRIF withdrawals after age 65 can be split 50/50 with your spouse. This helps to equalize income and can result in a lower total tax bill.
- Spousal loans – High-income earners are permitted to loan their spouse their investments for a set interest rate. The spouse has to pay interest, but then the capital gains are taxed in their name.
Once in retirement, a popular tax-minimization goal often becomes avoiding clawbacks from OAS (Old Age Security). “Consistent monitoring of a client’s marginal tax bracket each year helps to ensure government benefits are not clawed back,” says Ms. Norton.
One example she gives is selling a secondary real estate property (and realizing a capital gain) in the year before government benefits are to begin, if you are in a low marginal tax bracket at the time Mr. Pereira’s toolbox includes changing the mix of stocks versus bonds, a greater focus on dividend-paying stocks, and gifting money to family members.
A customized, regularly-updated plan for tax-efficient investing can make the difference in allowing clients to have a comfortable retirement. As Mr. Pereira puts it: “The less that goes to the Canadian Revenue Agency, the more that is left for a sustainable retirement.”
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