If you’re a high income taxpayer, you likely want ways to shelter your money from the tax collector.
Well, it’s the annual season to contribute to one of the perfectly legal tax shelters the federal government offers. That shelter, of course, is the Registered Retirement Savings Plan (RRSP), and the deadline for getting your 2016 contribution is March 1. Another useful government tax shelter is the Tax-Free Savings Plan (TFSA).
Both plans are simply containers in which you can hold various eligible investment products, such as GICs, mutual funds and even individual stocks and bonds. Other tax-shelter possibilities are spousal loans and universal life insurance. More on those later.
RRSP contributions are, of course, tax deductible and generally most Canadians take the deductions during their working lives when they’re in a higher tax brackets and take withdrawals after retirement when their tax liabilities are lower.
Many high-net-worth investors, however, max out their RRSP and TFSA contribution room quickly. But they make the most of the accounts by wisely splitting their investments between registered and non-registered plans.
For example, income from bonds and GICs is taxed at the highest rate. So it makes sense to keep these inside a registered, tax-deferred account. On the other hand, stocks and dividends fare better in non-registered accounts, as capital gains on shares and dividends from Canadian corporation are taxed at a lower rate.
But there are limits to how much you can put into to your RRSP. Most people can contribute 18% of their earned income to an RRSP. But that doesn’t work for high earners. For example, if you earned $350,000 last year, in theory you could contribute $63,000. But the contribution limit for 2016 is $25,370, plus any leftover contribution room from previous years. (The limit is 26,010 for 2017).
And of course, your spouse or common-law partner can open a plan to increase the investments and income stashed away tax free. However, contributions you make to a spousal or common-law partner RRSP reduce your deduction limit. The total amount you can deduct for contributions you make to your RRSP, or your spouse’s or common-law partner’s RRSP, cannot be more than your personal limit.
For TFSAs, the annual contribution limit is $5,500 for 2017, and the maximum cumulative contribution allowance since the accounts began is $52,000. So if you haven’t opened an account, you could contribute that amount this year and keep earning tax-deferred income. In each successive year, just contribute more. The amount is indexed to inflation.
Again, if you’re married or have a common-law partner, those amounts double. TFSA contributions can’t be deducted, but the income earned within the plan is never taxed.
Another way to shelter from tax is to lend your spouse an investment loan. You lend your spouse or common-law partner money and charge the prescribed rate of interest, currently 1% (don’t gift money because any income earned on the money will be attributed back to you and taxed in your hands). The interest rate can be locked in indefinitely at the time you set up the loan.
Your spouse or common-law partner takes the money, invests it, earns income on it, pays you the interest and then pays tax on the balance of the income at his or her lower rates. Therefore, you’ll save tax as a couple. Your spouse will have to actually pay you the interest every year by January 30 for the prior year’s interest charge.
This tactic makes sense, particularly if:
1. You lend a significant amount (thing in terms of hundreds of thousands of dollars),
2. The difference between your marginal tax rates is great, and
3. You’re investing for income.
It may also make sense if you’re expecting significant capital gains.
You also can shelter significant amounts of non-registered money if you take out a Universal Life Insurance Policy. The amounts have been reduced somewhat starting January 1, 2017, but not on polices taken out before 2017.
Here is the strategy. A Universal Life Insurance policy allows you to add additional investments into funds (stock, bond, global, domestic, etc.). These investments are tax sheltered if they’re held within a life insurance policy.
Universal life insurance has a savings feature that can be allocated into various active and passive investment options that grow tax-free. Fees tend to be higher than non-insurance solutions, so fees and tax savings need to be compared. Whole life insurance invests some of your premiums on a tax-free basis by the insurance company into unique asset classes, such as private placement bonds, residential and commercial mortgages, private equity and policy loans to other policyholders. Commissions are generally high up-front, so a whole life policy shouldn’t be a short-term commitment.
The amount you can hold depends on a number of factors. While there can be some drawbacks to investing in an insurance policy, for those holding significant non-registered assets, the tax shelter may outweigh any drawbacks.
However, you need to access the funds in a tax efficient way.
The key is to set up a joint policy with multiple people insured — so you might have a policy with you and your spouse and your parents. In some cases, if any one of the three or four people has an insurable event, it allows you to withdraw the accumulated investments funds with no tax implications. So, just like a TFSA, there was tax sheltered growth and no tax to withdraw funds.
Your advisor can provide more details on this complex situation.
Of course, these aren’t the only tax shelters out there. But beware of illegal mass marketed gifting tax shelter arrangements. These include schemes where taxpayers receive a charitable donation receipt with a higher value than what they paid. This can typically be four or five times their out-of-pocket cost. On its website, Canada Revenue Agency (CRA) says it “audits every mass-marketed tax shelter arrangement and no arrangement has been found to comply with the Income Tax Act.”
There’s a major distinction between tax avoidance (where you take advantage of the rules to minimize your tax bill) and tax evasion (where you try to hide income or break the law). The first is perfectly legal, while the second obviously isn’t.
If you’re considering entering into a tax shelter arrangement, get some advice from your tax advisor. Among Here are some steps the CRA recommends taking to help protect yourself and your money:
1. Know who you’re dealing with. Request and read the prospectus or offering memorandum and any other documents available in respect of the investment.
2. Pay particular attention to any statements or professional opinions in the documents that explain the income tax consequences of the investment. These opinions may tell you about potential problems.
3. Don’t rely on verbal assurances from the promoter or others.Get them in writing.
4. Ask the promoter for a copy of any advance income tax ruling provided by the CRA with respect of the investment. Read the ruling and any exceptions.
Individual taxpayers should be aware that the CRA could normally reassess returns up to three years after the date of assessment. The fact that tax shelter investements were accepted on initial assessment shouldn’t be interpreted as acceptance of the claim by the CRA. It may take more than one year to complete a tax shelter audit.
Consult with your advisor about maximizing your RRSP and TFSA contributions before thinking about other tax shelters.