Spending What You’ve Saved – How Will This Affect Your Tax Bill?
by Evelyn Jacks
Tax season is a great time to take stock of how your personal efforts
and after-tax results combine to give you the lifestyle you really want.
If you have some specific goals for 2005 that involve tapping into accumulated
assets, you may want to start planning now, and speak with your tax and
financial advisors as you sign off on your return for 2004.
There are several life changes that may require the use of accumulated
savings – births, deaths, marriages or divorce, to name a few. But
how does one approach the decision to withdraw money from registered or
nonregistered savings accounts, or to dispose of capital assets to fund
such life-cycle changes with a most tax-efficient point of view? How will
cashing in while you continue to accumulate savings affect your tax bill?
To preserve as much capital as possible, it helps to think about following
a tax-efficient order of withdrawal, taking care to “realize”
the least amount of taxable income possible. To manage this properly,
you may wish to think of your savings within three distinct categories:
- Tax-assisted accumulations: The ultimate purpose of an RRSP
is to fund specific income needs – during retirement, for example
– when other actively earned income sources diminish or disappear.
When the money is put in, you get a deduction for the capital, but take
it out and both principal and earnings are taxable. But it is also possible
to use the funds accumulating here on a tax-free withdrawal basis, to
buy a home (under the Home Buyer’s Plan) or go back to post-secondary
school (under the Lifelong Learning Plan). RRSPs also afford a great
opportunity to equalize income in retirement with your spouse or common-law
- Tax pre-paid assets: Any investments held in non-registered
accounts, like shares, mutual funds and bonds, and revenue-generating
properties are included in this category. These investments will have
been made on a tax pre-paid basis – that is, no tax deduction
is allowed when the principal is invested. Depending on the source of
capital, your marginal tax bracket and market timing, it makes sense
to plan to realize income from these sources on a diversified basis
– making sure that desired after-tax results are attained with
a good mix of interest, rents, dividends, capital gains, foreign or
other taxable income sources. The plan is even more tax efficient when
family incomesplitting opportunities are maximized.
- Tax-exempt assets: This can include your principal residence
and other significant investment assets. When markets are right, it
may make sense to sell or transfer these assets, or to tap into the
equity built up in these assets by prudently taking an investment loan.
Here are some specific concepts you might wish to speak to your financial
advisors about before you tap into these assets:
Tax-assisted contributions. Many people think about withdrawing money
from their RRSPs first in times of stress or need. But remember the big
red flag: both the principal and earnings must be added in full to your
taxable income in the year of withdrawal. Do consider the Home Buyer’s
Plan or Lifelong Learning Plan for tax-free withdrawals, but always remember
that you will forfeit the opportunity to continue to grow this principal
within the plan on a tax-deferred basis. Maybe that’s not a good
place to start.
A much better plan, if your timing is right, could simply be to create
new capital by making more RRSP contributions and claiming the tax deduction.
For this to work, you need to be age eligible, have the contribution room,
and have a net or taxable income to generate the tax benefits from the
RRSP contribution. Ask your tax and financial advisors to calculate just
how many new dollars you can create with new RRSP contributions before
you think about taking money from these savings.
Remember too that you can often use the tax system to create new capital
without coming up with any new money, by “flipping” assets
held in a non-registered account into an RRSP. However, be aware that
there will be tax consequences on the gains or losses at the time of disposition
of those funds into the RRSP.
Finally, tax-efficient withdrawal strategies should take into account
marginal tax rates during a taxpayer’s lifetime and at death. Sometimes
it makes sense to withdraw funds and generate the tax during a taxpayer’s
lifetime. For example, if your mom, a widow, will be in a higher tax bracket
at the time of death (when remaining accumulations are added to income
in full), she should obviously withdraw more taxable sums during her lifetime.
But this could also affect refundable and non-refundable tax credits,
and quarterly instalment payments, so proceed with caution.
Non-registered accounts. Income from property held outside registered
funds is generally earned as interest, dividends, rents or royalties.
These sums are reported for tax purposes according to a variety of rules,
- Interest is reported on an annual accrual basis.
Actual dividends earned are reported as distributed, but must be grossed
up by 25% on the individual return. A dividend tax credit then
reduces taxes payable later on the return.
- Rents are reported
on a net basis after deducting operating expenses and applying
capital cost allowance deductions to reduce net income to zero (losses
cannot be created or increased with a CCA claim).
- Royalties may
be subject to special resource allowances.
In addition, any increase in value in capital assets held outside registered
accounts will accrue on a tax-deferred basis until they are disposed of.
Then only 50% of the gain will be taxable. Should you incur losses on
the disposition of your capital assets, however, know that these are only
deductible against capital gains, but may qualify for “carryover”
provisions – that is, you can apply the loss against capital gains
three years back and indefinately into the future.
To minimize tax consequences, you may be able to control when you generate
the sale or transfer of assets (over two tax years, for example) or choose
investments that allow you to blend the withdrawal of tax-pre-paid principal
and taxable earnings – all with the goal of minimizing your overall
Tax-exempt property. The majority of Canadian taxpayers also own
some tax-exempt assets. This includes one principal residence per household,
or it can include life insurance policies or even the shares of a qualifying
small business corporation, which may qualify for a capital gains exemption
of up to $500,000.
But, of course, dipping into those significant resources will only work
if you are ready to sell and a willing buyer is present within your required
time lines. If this is not the case, you may also be able to borrow against
the equity in these assets, to leverage into new investment opportunities
with tax-deductible investment loans. Speak to your advisor about a prudent
approach that conforms to your risk tolerance level with this option.
Most important, because of our progressive tax rate structure under which
lower earners pay less, discuss opportunities to transfer funds to family
members to legitimately split investment income.
In short, depending on the diversity of your holdings, your marginal
tax bracket, and your family tax filing profile, there are several options
for income and equity creation to discuss with your financial advisors
when you need extra resources to live your life to the fullest.
Evelyn Jacks is the author of 30 best-selling books on the subject of personal income taxation, and the President of Knowledge Bureau, Inc., Canada’s leading professional education publisher in the tax and financial services industry, specializing in delivering courseware and information services to knowledge-based practices. For more information call toll free 1-866-953-4769 or visit www.knowledgebureau.com.
This article is written to be of a general nature and neither the author, her company, employees, subcontractors or others associated with The Knowledge Bureau can take responsibility for any results, positive or negative, taken by any persons. While the author received a fee to write this article, she is not in the business of providing advice on investment products and is not registered and licensed to do so, nor does the author have any compensatory relationship, or beneficial ownership
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