What is tax planning?
Tax planning is the process of organizing your finances so that you pay as little tax as legally possible – now, in retirement and even after you pass away. You can do this by taking into account your income now and your likely income in the future, your family situation, the types of investments available to you and their different tax implications, and more. At a basic level, tax planning entails finding out about – and taking advantage of – all available tax deductions, credits and exemptions that could apply to you now and in the future. Often, reducing taxes is best done by deferring payment of taxes until you are in a lower income tax bracket.
What should your plan include?
The tax efficiency methods and vehicles you use will depend on your income and tax bracket, your marital status, whether you have children and other factors. Most people are aware of the tax benefits of a Registered Retirement Savings Plan (RRSP) for tax deferral and reduction (you will most likely be in a lower tax bracket when you retire). But there are many other ways to plan to save tax.
If you are married (including common law), investigate ways of splitting income with your spouse to put either or both of you in lower tax brackets. Income splitting methods include pension splitting, sharing Canada Pension Plan benefits and making spousal RRSP contributions.
You can split income with other family members by contributing to a Registered Education Savings Plan (RESP) – earnings within the plan are taxed in the hands of your children (or grandchildren) when withdrawn for education. If you have a disabled child, you can set up a Registered Disability Savings Plan, and as with an RESP, earnings growth within the plan is taxed in the hands of the beneficiary, who will likely be in a lower tax bracket.
You can split income with either your spouse or a child using a prescribed rate loan. With this strategy, you lend funds to your spouse or child who is in a lower tax bracket. They use the funds to purchase investments in their name. The investment income is then taxed in their hands at their lower rate. The spouse or child must pay you the prescribed interest on the loan each year and you will pay tax on it. This interest will be a tax deduction to your spouse or child. The prescribed interest rate is 2% (January 2019).
Family trusts can be used to divide income among family members. Trusts are often used to own shares in a private corporation, with the trust then paying dividends to family members for taxation in their hands.
More tax savings methods
There’s more you can do beyond income splitting. A graduated rate estate is a way of designating your estate on death so that your estate pays tax as if it were an individual rather than a trust; that is, in graduated income tax brackets, rather than at the single highest marginal rate. Your executor will need to work with your accountant to make the necessary designation and to ensure graduated rate estate rules are followed.
Make sure you take advantage of all deductions and exemptions that apply to you. These are just a few:
If you borrow money to produce investment or business income, the interest paid on the loan is tax deductible. Investment counsel fees and accounting fees for tax return preparation are also deductible, as are legal fees you pay to collect employment income or to collect support payments from your ex-spouse.
The principle residence exemption usually means a significant tax savings. Under this provision, if you sell your primary home, you will not have to pay capital gains tax on all or a portion of your net gain (the portion is calculated according to a formula).
The capital gains exemption is another important tax relief provision available to many taxpayers. Under this rule, you can realize up to $866,912 (2019) of capital gains in your life free of income tax when you sell small business corporation shares ($1 million for a farm/fishing property).
This article has only briefly touched on a few tax planning approaches; there are many others. The strategies are all subject to rules and qualifications, and some are quite complex (and using them may raise other taxation issues). Meet with your accountant and investment advisor to create a complete tax plan. Your accountant knows the ins and outs of the Income Tax Act, how different types of investment and other income are taxed, what credits and exemptions you should be applying for now and planning for in the future, and how best to allocate your savings for tax efficiency.