Tag: Income splitting

Financial literacy is taxing … Or is that, “taxing” is financial literacy?

Whichever, it’s important either way.

I’ve been following with great interest the recent efforts in this country to look into and improve financial literacy.   

At time of writing, there is eager anticipation – and it’s not just me – for the release of the Task Force on Financial Literacy report, slated for the end of 2010.  As you are reading this then, hopefully the industry and the public in general are abuzz with the recommendations placed before the Minister of Finance.

As participants in the financial advice field, we obviously have an active interest in the present and future state of financial literacy.  Combined with the concurrent federal-provincial dialogue on reforming the pension and retirement system, I’d go so far as to say that this year will be viewed in hindsight as a maturity point in the development of the industry.

On an individual advisor level, this public spotlight presents the ideal platform for reinforcing to clients the value of your professional advice.  

Advisor as educator

Perhaps I would be in the minority for suggesting this, but I believe that the number one skill for an advisor is the ability to educate.

But shouldn’t expertise such as arithmetic talent, market familiarity and product knowledge be at least on an equal plane?  Without downgrading those requirements, I would contend that those are exactly that: “requirements”.  They are table stakes to get the license, but to really be a good advisor, you must be a good teacher.

Without that facility to build interest, foster comprehension and motivate action, all the rest is academic.

Speaking of tax 

Similarly, I hold myself to that standard in communicating with advisors on matters of tax and estate planning.  If I can’t explain it to you so you can explain it to them, then I need to go back to the drawing board.

To state the obvious, literally half of a person’s income could be spent in taxes.  The importance of having at least a working knowledge cannot be overstated.  As reinforcement (as if we need it), one of the most frequently mentioned items during the Financial Literacy consultation was “knowledge of the tax system, especially as it relates to credits and deductions that are designed to encourage saving”.

Here then are some fundamental tax learning points for you to share with your clients.  You’ll recognize most, if not all of these, and hopefully this will help you enunciate them that much more effectively with your clients.  If they can digest these guidelines then that should help pave the route from financial literacy to financial prosperity.

1. Marginal versus average tax rates

An obvious starting point is that the amount of taxes paid divided by income is your average or effective tax rate (ETR).  The rate you pay on the next or last dollar earned is the marginal tax rate (MTR).  A $75,000 income taxpayer has an ETR of 25% and an MTR of 35%. (All figures here and below are approximate 2010 national averages.)

2. METR

Building on the prior point, we now consider “marginal effective tax rate”.  An often cited example of this is the Old Age Security (OAS) clawback, which causes 15% of OAS benefits to be returned to the government when earnings are over a specified income level.  To illustrate, a $75,000 income retiree has an MTR of 35% on the next dollar out of a RRIF, but an METR with the clawback of almost 45% once you lose the after-tax value of the OAS clawback. (Plan carefully or lobby the government… or both.)

3. Income by source

RRSP/RRIF income is taxed at a person’s MTR at progressive rates as one moves up through the federal-provincial brackets.  Outside of tax-sheltered structures, interest is similarly taxed at MTR, but only one-half of capital gains is taxable, and the rate on Canadian eligible dividends (those generally arising in an investment portfolio) can range from to zero to a little more than the rate on capital gains.  At a $75,000 income level, the rate on these dividends can be as little as a third of the rate applying to interest or even less, depending on province.

4. Income splitting with RRSPs 

We income split with ourselves using an RRSP, pushing income from high MTR working years to expected lower MTR retirement.  A spousal RRSP likewise splits from now to retirement, and also with another person.  If a person expects to be at a higher MTR when the funds will be used, a tax free savings account (TFSA) will produce a better result relative to an RRSP.  Strategically, TFSA and RRSP complement rather than compete with one another  

5. Understanding TFSA

The $5,000 of TFSA contribution room is an after-tax allotment, whereas RRSP room is pre-tax.  Let’s say a $75,000 income taxpayer had maxed out her RRSP and wanted to know how much more of her current income she could get into a tax sheltered investment.  At 35% MTR, approximately $7,692 would allow her to make full use of her $5,000 TFSA room.

Income splitting in the TFSA era

The practice of income splitting has been around for decades.  Essentially it is the process of shifting income recognition from a high tax bracket individual to a low bracket individual, most often carried out between spouses.

With the implementation of the tax-free savings account (TFSA) in 2009, another legal avenue has opened up for those seeking to reduce household tax costs, both on its own and potentially in coordination with existing strategies.

Existing splitting strategies

Tax authorities will often seek to impugn aggressive splitting practices by attributing income apparently earned by a low bracket spouse back to a high bracket spouse. Still, there are many common strategies that are allowed and indeed encouraged by our income tax laws.

Second-generation income – Once income has been earned and recognized, the income on that income is taxable to the receiver spouse.  For this reason, one may choose to turn over such a portfolio more often in order to move more quickly into next generation income. 

Spousal loans – Income earned on money loaned from a high bracket spouse to a low bracket spouse will be taxed in the latter’s hands so long as required interest is paid.  Ironically, the recent economic downturn carried with it a positive twist for such loans as the prescribed rate has been at its lowest calculated point of 1% for the last year.

Fair market value exchanges – If a low bracket spouse provides assets of fair market value equal to money provided by the high bracket spouse, income earned on that money will be taxed to the receiving spouse.

Pension income splitting – Since 2008, one may elect to have up to 50% of certain pension type income sources allocated and taxed to a spouse.

Spousal RRSP – Contributions to a spousal RRSP may be withdrawn by that spouse and taxed to him or her in the 3rd calendar year after last contribution.  While taking care not to imperil later retirement needs, some such withdrawals could be timed to coincide with a spouse’s temporary low income period, such as a sabbatical or maternity leave. 

CPP pension sharing – Spouses may pool and then split their pension credits in order to shift some of the entitlement and taxation to the low income spouse.

TFSA strategies

One may provide money for a spouse’s TFSA, and the growth in value of the TFSA will belong to that spouse.  Essentially there is no income to be attributed.  That’s a $5,000 non-attributable deposit generating tax-sheltered income each year, with that figure indexed to inflation every 3 or 4 years.

To put the value of TFSA contribution room in perspective, remember that TFSA deposits are after-tax.  For a rough estimate of how that compares to pre-tax RRSP room, one divides by “1 minus marginal tax rate”.  For two spouses operating under a single income in a 45% bracket, their combined TFSA room equates to about $18,000 as a pre-tax figure – almost doubling the $21,000 tax sheltering room available under the RRSP alone in 2010.

If desired, that receiving low bracket spouse could pledge the TFSA as collateral to a lender in order to leverage invested assets.  As legal owner of the TFSA, all associated income would be that of the low income spouse, and of course the interest charges should be deductible. 

Arguably, the receiving spouse could employ the earnings from this leveraged strategy to assist in existing splitting strategies, for example to facilitate the eventual retirement of outstanding prescribed rate loans.  Care must be taken however to assure that the particular steps do not cross one over into the TFSA advantage rules and/or fall within the purview of the GAAR.  For these reasons, qualified tax advice should be sought before undertaking any more elaborate steps beyond plain vanilla spousal TFSA contributions.

Whether wealthy or not, the TFSA rules offer one further advantage to spouses, which is the ability to name a spouse as successor account holder.  At death, the account may roll to the survivor spouse, while having no effect on his or her TFSA room.  Be aware though that any unused TFSA room of the deceased spouse is forever lost.  

Accordingly, in situations where a serious illness has thrust upon the couple the need for terminal estate planning, it may be prudent to fund-up a TFSA before death, using a loan if necessary.  The loan could be retired after account transfer following death, thus preserving as much tax sheltering as possible for the widowed spouse.