If you are an active investor, your investment holdings probably include many different asset classes. For many investors, diversification is a very important part of the wealth accumulation process to help manage risk and reduce volatility. Your investment portfolio might include stocks, bonds, equity funds, real estate and commodities. All these investment assets share a common characteristic – their yield is exposed to tax. From a taxation standpoint, investment assets fall into the following categories:
The income from these investments are taxed at the top rates. They include bonds, certificates of deposits, savings accounts, rents etc. Depending on the province, these investments may be taxed at rates of approximately 50% or more. (For example, Alberta 48.0%, BC 49.8%, Manitoba 50.4%, Ontario 53.53%, Nova Scotia 54.0%).
These investments are taxed at rates lower than those that are tax adverse. These investments include those that generate a capital gain (stocks, equity funds, investment real estate, etc.), or pay dividends. The effective tax rate on capital gains varies depending on province from approximately 24% to 27%. For dividends, the range is between approximately 30% to 41.6%.
Tax deferred investments include those investments which are held in Registered Retirement Savings Plans or Registered Pension Plans (such as an Individual Pension Plan). One advantage of these investments is that the contribution is tax deductible in the year it was made. The disadvantage is that the income taken from these plans is tax adverse as it is taxed as ordinary income and could attract top rates of income tax.
The growth in cash value life insurance policies such as Participating Whole Life and Universal Life is also tax deferred in that until the funds are withdrawn in excess of their adjusted cost base while the insured is still alive, there is no reportable taxable income.
Very few investments are tax free in Canada. Those that are tax free include the gain in value of your principal residence, Tax Free Savings Accounts (TFSA’s) and the death benefit of a life insurance policy (including all growth in the cash value account).
While Canada is not the highest taxed county in the world (that distinction belongs to Belgium) it is certainly not the lowest. (According to the Organization for Economic Co-operation and Development, Canada sits as the 23rd highest taxed country in the world). It is also true that in addition to the taxes Canadians pay while they are living, the final insult comes at death.
Generally speaking, you have three beneficiaries when you die. You have your family, your favourite charities, and the Canada Revenue Agency. They all take a slice of your estate pie. Most people would rather leave more to their family and charities than pay the CRA more than they need to.
As our estates grow, they include funds that we intend to leave to our children and possibly to charity. They also include funds we are likely never going to spend while we are alive.
The secret to optimizing the value of your wealth for the benefit of your estate is to re-allocate those assets that you are never going to spend during your lifetime from investments that are tax exposed to those that are tax free.
One of the best ways to do this is through life insurance. As mentioned earlier, assets which are tax free include the death benefit of a life insurance policy. Systematically transferring funds from the tax exposed investments to, for example, a Participating Whole Life Policy, not only eliminates the reportable tax on the funds transferred, it greatly increases the overall size of the estate to be left tax-free to your beneficiaries – your family and your charities.
Let’s consider Ron and Sharon, aged 58 and 56 respectively. They have been told that they have a liquidity need of approximately $1,000,000 which would become payable at the second death. They are also unhappy about the taxes they are paying annually on their investments. They elect to re-allocate some of their assets to a Participating Whole Life policy for $1,000,000 with premiums of $31,890 for 20 years.
Over this period, they will transfer a total of approximately $640,000 of investments exposed to income tax to a tax-free environment. If we assume that their life expectancy is 35 years, the Whole Life policy will have grown to a death benefit of approximately $3,300,000*. This represents a pre-tax equivalent yield over this period of approximately 11%. Not only is there more than enough to pay the tax bill but there are funds left over for the family and any charitable donation they wish the estate to make.
In addition, with the transfer from a taxable to tax free investment, income taxes that would have been paid during their lifetime has also been reduced. Along the way, the Participating Whole Life policy has a growing cash value account which could be borrowed against should the need arise. At the 20th year for example, the cash value of the policy (at current dividend scale), would be slightly under $1,000,000.
This case illustrates only one example of how it is possible to optimize the value of an estate through asset re-allocation. By using funds you are never going to spend during your lifetime, you can create a much larger legacy to benefit others while reducing the total cost of your tax bill.
If you would like to investigate this concept to determine the value it can provide you and your family, please be sure to contact me. As always, please feel free to share this information with anyone you think would find it of interest.
* Values shown are using Equitable Life’s Equimax Estate Builder assuming current dividend scale for 2018.
If you are seeking ways to save in the most tax-efficient manner available, TFSAs and RRSPs can both be effective options for you to achieve your savings goals more quickly. However, each plan does have distinct differences and advantages / disadvantages. Let’s take a look at their key features:
- While a TFSA can be used for any type of savings, an RRSP is used exclusively for retirement savings.
- You can enjoy tax free withdrawals from your TFSA due to the fact that you make your contributions after you have paid tax, whereas the opposite is true for withdrawals from your RRSP (except in the case of lifelong learning plan and home buyers’ plan)
- TFSA contributions aren’t tax deductible whereas RRSP contributions are i.e. with an RRSP, you can deduct the contributions that you make from your income when you file your tax return.
- It is required that you use earned income to contribute towards your RRSP but this is not the case for your TFSA.
- You can continue to contribute towards your TFSA for as long as you like, whereas you must close your RRSP and stop contributing towards it when you turn 71 and purchase an annuity or convert it to a RRIF with the savings that you have made within the plan.
- You are able to specify your spouse as your beneficiary with both your TFSA and your RRSP, however there is a key difference with how your savings are treated upon your spouse’s death. With an RRSP, there will be taxes payable upon the monies left in the plan by your children who inherit it, whereas with a TFSA, tax is only paid on the increase in the value of the plan since the date of death in the year that it is inherited by your children. What’s more, no tax is payable if the value that they receive is less than the value of the TFSA at the time of death.
In summary, your individual circumstances will dictate which plan is the most appropriate for you, depending on your tax position and withdrawal intentions. The primary difference between both plans is the timing of the taxes payable i.e. if you want to defer the payment of your taxes, particularly if your marginal tax rate will be lower in retirement, an RRSP may be more beneficial for you. Alternatively, if your marginal tax rate will be higher when you plan to make withdrawals, a TFSA may suit you better.
RRSP or TFSA? What’s the difference? With the RRSP deadline around the corner, we’re here to help you figure out where you should invest.
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About Chris Geldert
Recognizing the difficulties navigating corporate structures and the insurance world I specialize in assisting business owners protect, realize and transfer the value of their business. I focus and guiding owners through the process, working with their various professionals, ensuring solutions are implemented to properly manage the risks and maximize the benefits. Above all I work to earn your business.