Wednesday, January 20, 2010

Tax Thoughts For A New Year

A new year invariably brings thoughts of new year resolutions. Notwithstanding the arbitrary nature of January 1, we tend to think it a good time to focus on self-improvement. With that in mind, what simple tax-planning resolutions should be considered for the coming year?

Tax Free Savings Accounts. By now, everyone is more or less familiar with the tax-free savings account (the “TFSA”). While contributions are not deductible, income earned within a TFSA is completely exempt from income tax – even on withdrawal from the TFSA. While one can carry-forward contribution room, it is better to contribute at the start of the year so as to start accumulating tax-free investment income as soon as possible. While the annual contribution amount is relatively small --$5,000 per year – remember that the tortoise (not the hare) won the race in the fable. Make the contribution early, and choose the investment wisely.

Registered Retirement Savings Plans. Many Canadians will contribute to a registered retirement savings plan (“RRSP”) during January and February – but the contributions will relate to the 2009 calendar year. All things being equal, you should be making your 2010 RRSP contributions in early 2010 so that you earn tax-deferred investment income inside the RRSP as soon as the additional contribution room becomes available. While withdrawals from the RRSP will have to be included in taxable income, this will occur down the road in retirement. In the meantime, you will be able to use that tax-deferred investment income to generate more tax-deferred investment income.

Managing Debt. If interest that you pay on a debt is not deductible for income tax purposes, you should generally – other things being equal – seek to pay down that debt before repaying debt that carries deductible interest. Non-deductible interest has to be paid with after-tax dollars, so non-deductible interest payments cut more into cash flow.

There is a fallacy that deductible interest is good. The most that can be said, however, is that deductible interest is paid with before-tax dollars and so is not as hard on cash flow as paying non-deductible interest. Even deductible interest payments, however, reduce cash flow. Whether deductible interest is good depends on the investment return generated by the borrowed money. If the investment return exceeds the interest cost, and allows you to service the principal payments, you are in good territory. As many found out to their dismay during the financial free-fall in 2008, however, investment returns can turn negative and margin calls do occur. Whether it is wise to invest with borrowed money is an entirely different question than whether deductible interest payments are cheaper than non-deductible interest payments. Keep the two questions separate.

Loans to a Spouse. In an earlier item, I suggested that a high-income spouse lend funds to a low-income spouse so that the low-income spouse can invest the borrowed funds and earn income that will be taxed at a lower rate of tax than if the income had been earned by the higher-income spouse. Any such loan has to bear interest at the Canada Revenue Agency prescribed interest rate in effect at the time that the loan is made. That prescribed interest rate is currently a mere 1%. That rate can be locked in for an indefinite period if the loan is properly structured. Any such loan should be clearly documented and the borrowing spouse must pay all interest to the lending spouse on an annual basis. While the lending spouse must include the interest in income, the borrowing spouse can deduct the interest payment and presumably can make a return of more than 1% so that any excess investment income (over and above the 1% interest charge) is taxed as the income of the borrowing spouse.

Further Reading. The Wealthy Barber may well be one of the best financial-planning books ever written – it even reads like a novel, which was a novel idea at the time. If you are considering making financial new year resolutions, I suggest that you read The Wealthy Barber and consider the ideas that it presents. While I have heard some complain that the book is no more than common sense, common sense is often defined as the sense that is not as common as one would like. If you are imbued with natural common sense, it does not hurt to review the basics. Like putting aside 10% out of every paycheque for investment.

I could go on with more exotic ideas on using holding corporations to invest corporate income that has been taxed at the low rate applicable to the first $500,000 of active business income earned by a Canadian-controlled private corporation, but this is supposed to be a piece on simple tax-planning strategies that can be implemented as part of one’s new year resolutions. So let me end off by simply wishing everyone a happy and prosperous new year, even if the coming year includes the implementation of the Harmonized Sales Tax.

By the way, don’t forget to get your hair cut on June 30th.

- Blair P. Dwyer

Visit the Dwyer Tax Lawyers web site
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Visit the Dwyer Tax Law web site
for information about our services and lawyers' profiles.

The above article provides general commentary of an educational nature. It does not constitute advice for any specific person or any specific set of circumstances. Because circumstances vary, readers should consult professional advisers in order to obtain advice that is applicable to their specific circumstances.