Different types of investments create different types of income. Today on ThinkSmart Senior Financial Advisors Rob McClelland and Mike Connon take an in-depth look at tax optimization; ways to avoid paying unnecessary taxes and triggering capital gains. They also discuss the advantages of the funds we use.
Transcription
Rob (00:00):
Hello, this is Rob and Mike from The McClelland Financial Group of Assante Capital Management. And this is Think Smart with TMFG today on Think Smart with TMFG Mike and I are going to be discussing things you can do to reduce your tax bill Mike. It is that time of year where we’re getting together with a lot of our clients and some people have already got their tax returns complete. A few have even got notice of assessments back from revenue, Canada
Mike (00:33):
Taxes aren’t going down, are they?
Rob (00:34):
They certainly are not going down. And, you know, we’re coming off a pretty good year in 2021. Some clients had some capital gains and things that they had to deal with. So I’ve had a few comments that their taxes are a little bit higher than they’re used to. And I thought it might be interesting for you and I to explore some of the things that we do internally, and that can be done to reduce your tax bill. And every dollar you save in taxes is, is, is huge. We all focus on investment return and returns are, are important, but your tax bill is equally important as is your return. So let’s explore the number, one thing that, and we’ll break it up into two groups. So for the pre-retired, those who are still working to me, the biggest thing you can do is still RSP contributions. It’s a hundred percent deduction of your taxable income.
Mike (01:36):
You know, it’s funny when I read articles, there always be every year we get the one person comes with article that says you shouldn’t be doing RSPs. And, you know, they look at the one exception in a million cases where the person has a, you know, high pension plan. They retire in a higher income bracket than they were in because they received a bunch of money is a very odd scenario. And usually I find as people looking to get published or looking to get attention,
Rob (01:59):
I would agree the RSP to me. If you’ve got the contribution room, you should be putting that money in. And you know, sometimes yeah, if your contribution room is big. So I had a client today that has over $200,000 worth of contribution room. Obviously, they shouldn’t be putting that kind of money in, and they’ve got to very carefully look at how much to put in. But even if they had $50,000, they should still put it into the RSP, let it grow free of tax. Even though they may only deduct $20,000 of it this year.
Mike (02:33):
Yep. That’s something most people don’t know about. And if you do a RSP contribution, if you have the room, you don’t necessarily have to deduct it all in the year, which you do the contribution. You can carry it forward and use in future tax returns still have the money grow tax free, not be fine because you’re still not over because you have the room, but pass the deduction onto the fall tax year. So you can spread out that deduction over, over a couple tax brackets to make sure you can write it all off in the highest tax bracket.
Rob (03:01):
Definitely. So the other one, and this isn’t necessarily a tax strategy, but your TFSA account, every year, you get $6,000 of new contribution room. At least that’s what the limit is for 2022. And what the TFSA does is it prevents taxable income from hitting your return on that $6,000. Whereas if you left that $6,000 in an open account, even if it had some dividends, some interest, and some gains, you’re going to have to pay tax on that better to get that money into the TFSA and get it in as early as possible, beginning of January is the best time to get those contributions in. A lot of clients do in kind contributions, where they move money from maybe an open account to a TFSA. It’s not really savings, but it’s still a good strategy to get that done before the open account starts triggering that income yep. Tax optimization. That’s something we do with all of our clients, explain to our audience what that really entails.
Mike (04:08):
Well, different types of investments create different types of income. If you have a bond, it’s going to pay interest. Sometime if the bond goes up or down a value, you can pay a capital gain too. But most of fixed income returns are in the form of interest. Interest is charged at your top marginal tax rate, whatever you pay on, let’s say the income you get from your employee, you’re going to pay the same as on interest income. The second piece of income you get is on dividends. Canadian dividends are tax preferred. You have the Canadian dividend tax credit, which helps you out, which means you’re probably paying about, I’m going to take a guess here 25 or 30% less tax than you would on a straight interest income when you get your tax bill. So that helps out. And that’s from Canadian. If you think of like a bank, that’s going to pay out a dividend of 3%, 3.5%, whatever you get ought to that, the income that you get off that dividend will fall under those dividend tax credit rules. The third is a capital gain. So a capital gain is when you buy an investment and in the future, you sell for more money. And those gains are going to be taxable as a capital gain, but only 50% of those gains get put into your taxable income. So again, it’s at one half the tax rate as let’s say a regular bond.
Rob (05:22):
So portfolio planning becomes very important, not just asset allocation. You know, how much should I have in fixed? How much should I have in Canadian companies, US companies, but where should I have those Canadian companies becomes extremely important.
Mike (05:37):
Think of all the different, the types of RSPs TFSAs and open accounts, they’re different vehicles, and you got to put the right thing in the right vehicle, right? So, if you have a Lincoln town car and you have a pickup truck and you have to carry some people to a nice engagement, you don’t want to throw them in the pickup truck. And if you want to take 10,000 pounds of gravel and bring it somewhere, you don’t want use your Lincoln town car. There’s different vehicles should have different objects in them. So RSPs, similarly should have fixed income inside them. You don’t want to take all these things, particularly anything that’s in the US. That’s another thing that happens in the us when you make money in the US, the US government takes taxes at source. And if it’s an open account, you get credit for all the money. The US government has taken ought to that investment in if you put that inside an RSP you get no credit for that. So if it’s an open account and the us takes tax off of the gains, when you have filed on your return, you get credit on the open account for any tax that was already paid to the US. It’s a foreign tax credit.
Rob (06:42):
So let’s use an example there. Let’s say you had a $10,000 dividend from a US company. The US government’s going to take some tax on that. Yeah. And you can get a credit for that on your tax return, because it was in your open account. If you did it in your RSP account, it’s lost, you don’t get that. Money’s gone. So if they withheld, let’s say $2,000 of taxes that money’s gone. Whereas if it’s in your open account, you can get that $2,000 as a tax credit, which reduces your tax bill by the $2,000.
Mike (07:15):
Yeah. People sometimes ask what you, what we do differently than other firms. A lot of times when people have open accounts and RSPs, we either have a full portfolio. We use something we call the 2 fund or 3 fund solution. And the reason why we did that rather than use the balance fund is that gave us the ability to go and put these right types of accounts, the right types of investments into the right types of an account. So, a balance fund is great if you have an RSP or just an open account, but if you’re dealing with RSPs and open accounts and TFSAs, you want some separation in your investments, because they’re all taxed very differently. And it allowed us to run very simplified, balanced portfolios while keeping them fully tax optimized, which saves people believe it or not a ton of money.
Rob (07:59):
The next area that I think is important is to, to look at the types of investments that you’re using in each of the different accounts. And so as many of our audience know, we have been using one company and we’ve been using that since I think 2005 now. So it’s, it’s a long period of time and there’s, there’s some reasons we’ve really found them to be advantageous. And I, you know, these are the things that impact individual’s taxes. So the funds we use have very low turnover. They don’t do a lot of trading. And so they don’t trigger a lot of capital gains inside the fund. So that reduces our client’s tax bill and that money is allowed to grow free of tax until those gains are eventually triggered. Number two, we use funds that have a low expense ratio. When you have a low expense ratio that provides, that allows more of the income that’s produced inside the fund to come to the investor. And that income is often capital gains and dividends. So it’s taxed at a lower rate. We’ve also started to use more balance funds. The advantage of a balance fund is we’re not having to rebalance the account and trigger gains and losses. The balance fund is doing a lot of that work for you by using the inflows where other investors put money in and out,
Mike (09:21):
It’s the right way to do tax optimization. We saw in the past, if you go back four or five years, the industry was pushing something called corporate class funds. And remember we took a look at it. We went and everyone was advertised. And every bank you went into talking about how great their corporate class structure it was. And we went and did some investigation to see how it works and why it works. And the reason it was being more successful on some of these structures or the fees were so high, it was taken away their returns. That would be taxable. Wasn’t doing any good. It’s just it turned out if you were invested in a fund with very low fees and very low turnover, corporate class, wasn’t doing you all that much good. And since then, corporate class has sort of fallen apart quite a bit.
Rob (10:06):
It really, it hasn’t completely disappeared, but certainly it’s not being marketed the way it was in the past. Another thing that I always think is important is if you’re using equity mutual funds where it’s a hundred percent equity, make sure there’s not a lot of cash inside those funds. You want that cash to be less than one or 2% of the total. Sometimes funds would carry five or 6% in cash just to meet redemptions that creates interest income. And that creates taxes for the individual. So you want funds. If they’re saying they’re a Canadian equity fund, you wanted at least 98% all in Canadian equities, you didn’t buy a Canadian equity fund. That’s sitting in 5% cash.
Mike (10:50):
And again, look at the funds, look at the distribution record on them. You want funds with low distributions. And we’ve found that within our philosophies that distributions have remained somewhere between two and 3% on an annual basis which is pretty low. You don’t have to pay that much tax. Even when you have a decent year and you see double digit returns, the distributed income is still relatively low on these funds, and you got to be careful. We’ve learned in the past, back in the year 2000, as we said, we always learned from our mistakes when people were buying funds later on in the year, and there are massive distributions at the end of the year. And you got to be very careful and be aware of what you’re buying. You should always understand what you buy, not just what a salesman told you, understand how distributions work, understand how the company handles that, understand the unrealized gains inside the funds. There’s a lot of stuff to understand in there.
Rob (11:39):
That covers a fair bit of the subject for those individuals who are pre-retired. And some of that also carries over to those who retire. A lot of those things we discussed are equally important. What are some of the things that retired individuals can do to reduce their tax bill?
Mike (11:58):
Number one, just write a letter. There’s a form to the government that can allow you to split your pension plan. You have to split that with the government rather than on your tax return. Second piece they have is seniors are allowed to split income nowadays. It’s not, it’s a huge deal because we remember the days when there was no income split in, it was terrible. One person would lose their Old Age Security. One spouse was in a huge tax bracket. The other one had no taxes. We had to do spells of RSPs through all their life to try to equalize things. It was a nightmare. So they brought that in a long time where that’s been a phenomenal thing and today’s tax programs do a great job at optimizing how to split your income.
Rob (12:37):
Do you recommend doing your own taxes? No. Do you do your own taxes? No, but you and I could. Yeah. We know enough about the tax system, but we don’t, and it is just one of those things that, and, we have you and I each have clients to still continue to do their own taxes and some of them manually. And I look at it and I keep telling them not to be doing it. I just, for, whatever the cost is. I mean, we have our own tax service that’s a reasonable price, but whether you use that or not, I think you need to get it professionally done. It’s no different than a will or a power of attorney. Don’t do it yourself.
Mike (13:14):
They see things, they have the experience, and they see things that you miss. Sometimes you can do your tax return and the government says it’s okay. And you think you did a good job, but you don’t know what you forgot to put on it. You don’t know how much less you could have paid and you had a professional do it.
Rob (13:30):
Definitely. Definitely. What are some other things retired individuals can do. One of the things whether you’re retired or not retired, we talked about charging the TFSA fees to your open account. So, advantage of the TFSA fees, you’re going to pay a fee on your TFSA. If you’re working with an advisor there, there might be a, you know, a 1% fee or, more, you can take that fee and have it come ought to the open account advantage there, the TFSA grows faster. The open account grows slower. And if the open account grows slower, what does it mean? Less tax?
Mike (14:09):
The other thing to go, and we haven’t even mentioned this already is make sure your, your fees aren’t embedded, you know, make sure your management fees aren’t buried into MERS on the mutual funds. Still probably a large percent of the industry works that way. We have fee-based accounts and you see the advisor fee and for the advisor fee, that’s something that you can deduct from your taxes. And when you mix that into the MER into fund, you don’t get a direct deduction from that. And remember that goes early on in the tax return. What people forget is that actually goes before they do the OES claw back numbers, right? So it’s a big deal. Sometimes if you have large accounts, that fee brings down the income to a point where they no longer experience an Old Age Security claw back.
Rob (14:48):
And the advantage there, the Old Age Security claw back is like a double tax. You’re still paying tax, but you’re losing the old age security, which means it’s like almost a double tax.
Mike (15:00):
It’s additional 15% on top of your tax bracket. So if you’re 40% now you’re hitting at 55.
Rob (15:05):
The other thing that I think is, and this is something we’re able to do as advisors and individuals would be able to do it as well, if they were doing their own. But you, especially with retired individuals, you need to be planning every year where you’re taking any money you want to spend where you’re taking it from. Are you taking it from the RIF? Maybe you still have accounts that you haven’t converted from an RSP to a RIF. Maybe you want to start taking it from that RSP. I’ve had a couple situations near the year end where I’ve actually taken money out of the client’s TFSAs rather than taking it from their open account. And then in January of the next year, I put it back into the TFSA.
Mike (15:48):
TFSAs are an incredible tool, and they allow you to decide when you want to claim the income that you need in that year, they can go and float you through a year. And people asked when do I get out? My TFSAs generally speaking. The TFSA should be there full when you die. I mean, that’s the last thing you should ever get it, because that’s your, that’s your tax-free growth. And you can use it to go and pull things over between the end of the year and the next year when you need money, but then you fill them up right away and that’s the best growth you can have. And generally speaking, the tax free savings account, if you leave a listed beneficiary, it goes tax free probate through to whoever you listed in your as a beneficiary on it.
Rob (16:27):
I’ll use an example. I had a client, he wanted to give some money. His wife had passed away. He had he had received her TFSA as well. So that TFSA was well over a couple hundred thousand and he wanted to help out some of his grandchildren. And he wanted to give $200,000 from his open account to his grandchildren. What we determined the better strategy was to actually use the TFSA for part of it and trigger small part of the capital gain this year and a small part of the capital gain. The next year we saved him probably about $10,000 in income tax. Just by using that TFSA account with a little creativity. Yeah.
Mike (17:07):
You have to pay attention to marginal rates.
Rob (17:09):
I always think everyone focuses on rate of return. Mike taxes is equally important. So if you’re looking, if you’re, if you’re talking to you know, a friend or another advisor, something like that, and they’re raving about their rate of return, how well they’re doing on a certain investment, ask them, well, what are the tax implications of that? See if they have an answer, if they do good for them, they understand their tax situation. Most people don’t understand their tax situation.
Mike (17:43):
Yeah. Rates return have risk involved in them. Whenever you get an extra rate or return over the index, you’ve taken additional risk on when you get money back in tax, you haven’t taken any additional risk. You just get what’s owed to you. So that’s why you need an accountant. Because he’ll tell you what is owed to you. So you can pay least amount of tax bill as possible. Given your current situation,
Rob (18:04):
Saving taxes. That brings us to the end of another week. This is Rob and Mike with Think Smart with TMFG
Assante Capital Management (18:30):
You’ve been listening to The McClelland Financial Group of Assante Capital Management Limited Assante Capital Management Limited is a member of the Canadian Investor Protection Fund. Any Investment Industry Regulatory Organization of Canada insurance products and services are provided through Assante state and insurance services incorporated. This material is provided for general information and is subject to change without notice. Every effort has been made to compile this material from reliable sources. However, no warranty can be made as to its accuracy or completeness before acting on any of the previous information. Please make sure to see a professional advisor for individual financial advice based on your personal circumstances. The opinions expressed are those of the authors and not necessarily those of Assante Capital Management Limited.
