This is the third in a series on tax burdens and strategies to get around them.
There are key strategies for tax-efficient investing, one of which is to review your portfolio of off-farm investments on a regular basis. Ideally this should be done before year-end so you have time to reduce your tax burden.
There are three basic pillars of tax-efficient investing – income deferral, income splitting and income conversion.
Income deferral may allow you to take advantage of the situation should your marginal tax rate drop in years to come. Due to inflation, it also will allow you to pay off your tax bill in the future with money that is worth less than it is now, effectively discounting your tax bill.
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Your Registered Retirement Savings Plan is a prime example of income deferral allowing you to shift your tax liability forward from one year to the next or many years into the future. Tax-sheltered investments such as flow-through shares of Canadian companies that explore for minerals, oil and gas also receive preferential tax treatment.
Income splitting is the second pillar of tax-efficient investing. This allows you to reduce the overall family tax bill by shifting invested money and the income it generates away from the highest income family member to ones who are taxed at lower levels.
Because there are a number of twists and turns with income splitting, it is always advisable to seek professional financial advice before making an investment decision. Generally, however, the highest income spouse should pay all the family expenses that are not tax deductible while the salary and other income of the lower income spouse is used for investment purposes.
This will result in the family’s investment income being taxed at a lower rate.
The last pillar is income conversion. In your non-registered investment portfolio, interest income is fully taxable just like salary and other ordinary income. Canadian dividends and capital gains, on the other hand, receive preferential tax treatment.
Although the tax rates vary by province, on average, you will pay about 20 percent less in taxes on eligible dividends and capital gains than on ordinary income.
One strategy is to keep your fixed income investments (taxed at highest rate) in your RRSP to defer tax on the interest income they generate and hold your equity investments in your non-registered account to take advantage of the preferred tax rates on dividend income and capital gains.
There are many other opportunities to convert income, but these too should be considered with a financial-tax adviser familiar with personal, family and business investment goals.
Larry Roche is a tax analyst with farm taxation and planning specialists Farm Business Consultants Inc. He can be contacted at fbc@fbc.ca or call 800-860-7011.
