Tag: Credit/debt

A policy loan and capitalized interest may be taxable, as well as a debt to the insurer

At issue

Life insurance is almost always tax-free on death of the life insured. While that person is living and where the insurance is primarily designed to fund a death benefit, the policyholder still has no income tax concerns.

Where a policy has investment and savings features, the policyholder can be exposed to tax. Accessing a policy’s cash surrender value by way of a withdrawal will be a partial disposition, a portion of which will be taxable if the cash surrender value (CSV) exceeds the adjusted cost basis (ACB) at the time.

By comparison, generally no tax applies on a policy loan up to the ACB, but any amount over that would be taxable. And when a policy loan is used to investment outside the policy, there can be not-so-favourable tax implications. This was outlined in a CRA letter from mid-2017 in response to a taxpayer inquiry initiated about a year earlier.

Income Tax Act ss.20(1)(c) & (d), s.148(9) and Income Tax Regulation s.308

ITA ss.20(1)(c) & (d) allow a deduction for interest (simple and compound, respectively), where borrowed funds are used to gain or produce income. The relevance of this will become clear in the following discussion of the CRA letter.

There are numerous sections of our tax legislation and regulations that are networked together to address the complexity of life insurance. At the heart of it is s.148(9), and the many definitions contained therein, including what constitutes a disposition of a policy, how to calculate the proceeds on a disposition, and how to determine the portion of the disposition that is taxable.

As discussed in brief above, the determination of taxability depends on a policy’s ACB, also defined under s.148(9). The key components of ACB are paid premiums that increase it, and the annual charge of net cost of pure insurance (NCPI, as defined in ITR s.308) that reduce it. Importantly, taking a policy loan decreases ACB, whereas repaying the loan generally increases ACB.

CRA 2016-0658641E5 – What are the tax implications of capitalized loan interest?)

A policyholder contacted the CRA with concerns about the fairness of the tax treatment of life insurance. The policyholder’s loans and accrued interest comprised a debt owed to the insurer that will be deducted from any payout on the policy if still unrepaid at death. Even so, the policyholder received a T5 tax slip reporting taxable policy gains related to the policy loan.

The CRA representative outlined the key definitions in s.148(9) and elsewhere before turning to the details of this particular policy loan. The borrowed money was invested for the purpose of generating income, and the policyholder/taxpayer claimed the interest as a deduction pursuant to ITA s.20(1)(c) and/or (d). Furthermore, interest on the loan was not being paid by the policyholder directly; rather the interest was being capitalized within the policy.

The writer confirmed that the combination of claiming the interest deduction and capitalizing the interest resulted in a disposition pursuant to the definition of that term in s.148(9). In turn, the ACB must have been reduced to nil in the course of these dealings, as the disposition was confirmed as taxable.

Practice points
  1. Life insurance generally accumulates tax-free, and pays out tax-free.
  2. A policyholder is more likely to face tax on a withdrawal than a policy loan.
  3. Sometimes a policy loan can result in tax, even though interest must be paid to the insurer and the loan amount reduces the death benefit.
  4. In a closing point in the 2017 CRA letter, the writer noted that many rules have been modified for policies issued after 2016. Check with your insurer how this may affect your policy dealings.

It’s a student credit card but it’s an adult debt

My best friend has two kids at university, and another heading there next year. While on speakerphone in his car, he shared with me that the elder two just received their first credit cards. I’m not quite sure what he said next, as it was a bit muffled by the “woo-hoo” coming from his youngest in the passenger seat.

You may laugh, but for me – with three of my own eventually heading to post-secondary – that’s a bit of a nervous prospect. So while I’ll resist going daddy-knows-best on you here, allow me to share some lessons I’ve learned that can help keep that credit comfort from becoming a debt dilemma.

Necessary access to money, but not necessarily more money

There is no point in pretending that having a credit card is a luxury. For many young adults like you, it is a necessity in order to manage out there on your own. You can’t rent a car, book accommodation or secure an increasing range of services without one, even if you have the money ready to pay right away.

Of course it’s not open-ended. You will have a credit limit, and it’s important to keep that in perspective. It’s tempting to start believing you have more money, but you don’t.

In fact, if you spend more than the money you have available to pay off the card balance, you will have less money. By that I mean that you must pay interest if you don’t pay off your balance at the end of the month.

Minimum payment. Maximum cost?

The minimum payment shown on your credit card will be much less than the amount you spent with it in the month. Too often it is (mis)understood to be the suggested amount for you to pay. It is not. It is the amount you are required to pay in order to remain in good standing with the card issuer.

If you pay anything less than the full balance then you will pay interest on that full balance, not just on the unpaid amount you leave behind.

That also means that your next statement will include both that unpaid balance and your continuing spending. That can put you on a treadmill that is harder and harder to get off as the months roll on.

Simple rules to follow

A good practice is to only use the credit card as long as you have the money available to pay it off. That may not sound like much fun, but this is not a game. It’s your financial future.

Start by checking your money balance at the start of the month. Each time you use your card, be sure to get a receipt so you can keep running track of what’s available. In fact, your mobile app or online site may have a function to alert and track that for you automatically.

Beyond the mental note, you could make payments during the month, or set aside the funds in a side account if you prefer. Whichever approach you take, you put yourself in a better position to zero out that balance when the statement arrives.

By being conscientious, you will be able to enjoy the freedom and flexibility a credit card offers, while gaining understanding and control over your finances.

Your tax refund pre-funding an RRSP tax bill

And nine more smart things you can do with your refund

Whether it arrives by mailbox or inbox, a tax refund can feel like “found money.” But alas, it’s not; it’s basically an overpayment of tax that the government eventually gives back to you – at a zero rate of return.

For many of us, it’s the result of payroll taxes being withheld during the year based on assumed annual income. The full picture only becomes clear once your tax return is filed and all credits and deductions are fully accounted for.

When the refund does arrive, what you do with it can have significant long-term implications. Contributing at least some of it to a registered retirement savings plan (RRSP) could be a way to systematically pre-pay future tax on the plan. Here are the numbers to illustrate that strategy and a few more tax-savvy options to consider.

1. Grossing-up your RRSP

The apparent simplicity of RRSP arithmetic can be deceptive. For a person at a 40% marginal tax rate, a $1,000 contribution will generate a $400 refund. But that is literally only half the story, as the eventual drawdown will be taxable, netting right back to $600 spendable. Some savers may be quite content with that, knowing that in the meanwhile growth will be enhanced by the tax-deferred nature of a registered account.

On the other hand, some of that future tax liability could be pre-funded by contributing the refund back into an RRSP. To give full effect to this, each successive refund ($400 + $160 + $64 + …) would have to be similarly applied. In truth, this is simply an increase to annual savings but with a specific purpose in mind. Leaving aside investment returns, this would build the principal towards $1,667 in this example, which nets to $1,000 spendable. 

Now obviously a person’s tax bracket can vary over time, with the key expectation of being in a lower bracket in retirement. Rather than being a drawback to a pre-funding strategy, it makes even greater use of tax breaks in high-bracket years to fund future low-bracket retirement-income years.

Given that tax refunds are themselves tax-free, there is no drain on future income, so the process can effectively be self-funding. It takes some discipline, but ideally a conscientious savings habit and a tax pre-funding strategy could operate in concert on an ongoing basis.

Reduced withholding at source

For some, a refund may instead be viewed as cash that had been needed for current expenses, but was trapped in the tax system. If that’s so, an alternative is to file Canada Revenue Agency Form T-1213 to reduce tax deductions at source. In our example, this would have released the $400 as cash flow during the year, though the net RRSP contribution is left at $1,000. 

Alternatively, if the household budget can bear it, the pre-funding strategy could be coordinated with Form T-1213. In our example, the RRSP contribution would need to be $1,667 presently, as opposed to building in that direction over the years. 

2. Spousal RRSP

A spousal RRSP builds on the use of an RRSP to arbitrage from high to low tax brackets across time by also doing so across taxpayers – to a spouse expected to be at a lower future tax bracket. 

3. Pay down discretionary non-deductible debt

Regardless why it’s there, this kind of debt can often compound against us faster than we can accumulate savings. Eliminate such costly commitments as soon as is manageable.

4. Retire RRSP loan in the current year 

An RRSP loan can help get money into an RRSP, but if not paid off in the current year, it puts a strain on future years’ living expenses and savings. As well, the interest is non-deductible.

5. Mortgage reduction

Importantly, a mortgage funds future housing, but principal and interest are non-deductible. Retiring a mortgage allows more of a monthly budget to be devoted to retirement savings. 

6. Tax-free savings account (TFSA)

Funded out of after-tax money, the TFSA allows tax-free growth and tax-free withdrawals. The annual allotment of TFSA room for 2016 is $5,500.

7. Registered educations savings plan (RESP)

An RESP boosts education saving through income splitting, tax sheltering and government grants of up to 20% federally, with some provinces offering further financial support.   

8. Registered disability savings plan (RDSP)

Families with disability issues can face large financial challenges. The RDSP enables income splitting, tax sheltering, free government bonds and up to 300% in matching grants.

9. Non-registered investments

Registered savings form the core of retirement savings. Projected spending patterns may show a need to supplement that, and investing a refund can get that part of a plan underway.

10. Live it up … a bit

After all, saving is just spending-in-waiting – but it’s a good idea to try to keep it in balance.