Minimizing or Avoiding OAS Clawback with Corporate Class Funds
by Evelyn Jacks
There are many ways to generate new dollars for consumption and savings:
personal productivity (employment or self-employment), investment (interest,
dividends, rents or royalties) and income that is generated in selling
capital assets that have appreciated over their cost bases.
Each dollar generated will have different tax consequences. Furthermore,
the timing of income realized or reportable for tax purposes is very important.
A dollar kept in an investment portfolio today and out of the hands of
the tax department reaps significantly more rewards in both the short
and long term. When we defer tax to the future, we avoid higher tax brackets
and their progressively higher tax rates (See Table 1). Investors who
are subject to quarterly tax instalment payments benefit immediately from
such tax efficiencies.
However, there is another important short-term advantage – the
avoidance of “clawbacks.” Our income tax system provides several
tax preferences to families with specific circumstances. For example,
taxpayers should always try to maximize refundable and non-refundable
tax credits or social benefits like Employment Insurance or Old Age Security
(OAS). These provisions are income-tested. Once the taxpayer’s net
income on the return rises above a certain level, more of the benefit
is “clawed back” or repaid to the government.
Taxpayers and advisors who fail to create tax-efficient income structures
throughout the year can undermine their wealth accumulation strategies
by allowing rising income levels to boost them into the next tax bracket.
This can reduce monthly income sources from social benefits such as OAS
and can lead to higher quarterly instalment payments, which grab cash
flow from other investment opportunities.
Tax-efficient solutions are critical. Clients who face clawbacks of social
benefits like the OAS or Child Tax Benefits and other social benefits
like Employment Insurance are subject to much higher marginal tax rates.
That’s because each additional dollar earned is subject not only
to a potentially higher rate of tax, but also a reduction in benefits
or credits available.
Such tax inefficiencies force the taxpayer to save the last dollar left
after tax – a much smaller figure than the first dollar earned.
The result is a spiral of underperformance over a lifetime of savings.
That’s why it’s important to focus on a client’s marginal
tax rate – how much is paid on the next dollar earned. See Table
3 for examples.
It’s also key to manage dividend income levels, in particular,
as the dividend income “gross-up” of 25% forms part of the
net income calculation for clawback purposes.
In your efforts to help clients manage their income structure around
tax brackets and clawback zones, consider the merits of corporate class
funds. Corporate class funds are a tax-efficient solution for clients
who have maximized RRSP contributions, wish to achieve powerful portfolio
growth, and seek to minimize net income.
Within a corporate class fund, income distributions are minimized and
capital gains are deferred until the investor redeems from the corporation.
Furthermore, within certain types of funds, the advisor has the opportunity
to earn more tax-efficient capital gains income, rather than more highly
taxed interest or dividend earnings.
These features offer the potential to maximize tax deferral, better manage
clients’ income structure and thereby minimize the effects of clawbacks
on the tax return.
Consider the following example:
The OAS clawback will kick in when individual net income levels reach
$60,806 during the tax year 2005 and will wipe out the OAS when income
reaches $98,725. Recipients will be required to repay the lesser of the
OAS they received in the year or 15% of their net income over $60,806.
Assume the taxpayer had individual net income of $96,000, comprised of
private and public pension income sources, and a variety of investments
generating income primarily from interest and dividends. The clawback
of the OAS in this case would be $5,279, computed as follows:
$96,000 less base amount $60,806 = $35,194 x 15% = $5,279
This clawback eats up most of the OAS receivable. The advisor can assist
the client to keep more of the OAS by structuring affairs to realize less
taxable income, such as by choosing to generate tax-deferred capital gains
with corporate class funds. In this case, the taxpayer would realize a
return of over $3,000 after taxes annually through eligibility for the
OAS, if taxable income fell below the clawback thresholds.
Furthermore, a reduction of taxable income could also reduce the size
of quarterly tax instalments.
While it may appear that the clawback of a relatively small pension benefit
such as the OAS may not be of huge consequence to some taxpayers at higher
individual income levels, be aware there are other implications of significant
concern to those who are trying to manage capital preservation while dealing
with unfortunate life circumstances.
For example, those taxpayers who are confined to a nursing home will
benefit from reduced income levels, as per diem rates at nursing homes
are often based on net income. Similarly, publicly funded drug payment
plans are also often based on the size of the taxpayer’s income.
These “off-return” clawbacks can significantly erode capital,
as seniors are forced to tap into their savings to pay for expensive
Corporate class funds can be an important tool in managing a taxpayer’s
net income, thereby reducing costs of personal taxation and user fees
in the community.
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 regarding the sale
of investment products discussed herein.
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
regarding the sale of investment products discussed herein