Stealthy year-end tax planning is a critical task for investors and their financial professionals alike. The strategies employed now will determine how much money remains in Canadians’ pockets and how much goes to the Canada Revenue Agency (CRA), over the long run.
That task is especially pertinent this year for two reasons: the discussion of new taxes on wealth is more frequent and the intergenerational transfer of wealth continues unabated as Canada’s population ages.
Here are five vital year-end tax strategies to consider before the calendar turns to 2020:
1. Have a sound tax-free savings account (TFSA) strategy in place
The TFSA is a critical cornerstone of family tax planning. But it is also the investment that can facilitate introductions to the next generation of savers and inheritors. That makes it a win for investors, their adult children and financial processionals.
Consider that a pain point is CRA’s attribution rules, which generally thwart an investor’s effort to transfer capital and investment income to a lower-income spouse or child. There are a few exceptions. One is to gift money to adult family members who are residents of Canada, so that they can make a contribution into their own TFSAs. Future capital and income withdrawals are tax-free. Plus, there is no attribution of either back to the giver.
There are various other year-end considerations when it comes to TFSAs. First is the recontribution limitation; that is, withdrawals made from a TFSA in the current year cannot be added back into contribution room until the beginning of the following year.
For example, assume an investor needs to retire some consumer debt. It’s best to do that sooner rather than later. But when is the optimal time to tap into the TFSA for help? The answer is before year-end. Money withdrawn in December 2019 can be recontributed anytime in 2020 to continue earning investment income tax-free. In contrast, money withdrawn from the TFSA in January 2020 cannot be recontributed until January 2021.
Investors should also be aware of how expensive TFSA overcontributions can be; a tax of 100 per cent of the overcontribution is charged. This can happen if there are multiple relationships with various financial advisors, when do-it-yourself investors find it difficult to keep track of their TFSA contributions, or when the information on the CRA’s My Account portal is out of date. Thus, advisors should always try to bring personal net worth statements up to date at year-end for a check-up.
Investors should also know that earning business profits within a TFSA – including through day trading –throws it offside. Again, the penalties and potential interest costs are significant.
Finally, the TFSA is also a good place to hold highly-taxed sources of investment income: interest, then dividends, then capital gains. That’s something to consider when rebalancing various accounts at year-end.
2. Manage interest deductibility
Investors who are taking advantage of the current low interest environment need to be reminded about the following tax rules:
- Borrowing to maximize contribution room in a registered account (i.e. TFSA, registered retirement savings account) is not usually recommended as the interest on the loan is not tax deductible.
- Interest paid on securities that have no potential to earn passive income (i.e. there will be capital appreciation only) is not deductible.
- Interest on loans taken to buy vacant land is not deductible either, unless there’s rental income.
- It’s possible to continue to deduct interest on an investment loan even after an investment is sold provided a new investment is acquired.
- It’s also possible to deduct interest on assets with diminished values. That is, an asset acquired with an investment of $100,000 may now be worth $10. The interest will continue to be deductible in full.
3. Offset winners and losers
Harvesting capital losses before year-end will help reduce capital gains generated this year. Most people know that. However, when there are no capital gains to report, those losses can still be valuable. They can generate new refunds by offsetting capital gains reported in “carryover” years.
Specifically, when capital losses remain unabsorbed in the current taxation year, they can be carried back to offset capital gains declared in any of the previous three taxation years. The resulting refund can be reinvested to generate more wealth.
It’s also possible to carry forward net capital losses to offset capital gains an investor plans to generate in future years. Even if no further capital gains are earned during a taxpayer’s lifetime, unused capital losses are very valuable on the final return, when the goal is to enable the most tax effective wealth transfer to survivors.
On the final return of the deceased, one of two write-off options are possible. For the first option, capital losses will offset capital gains in the year of death, or can be carried back to offset gains in the three immediately preceding years. For the second option, there’s no carry back, but losses remaining after offsetting capital gains in the year of death can be used to offset all other income earned that year and the immediately preceding year.
For shareholders of qualifying small business corporations there is an extra wrinkle: any capital gains deduction claimed will reduce unused capital losses available for other purposes.
4. Mind the Alternative Minimum Tax (AMT)
For those investors who think increased taxes are on the horizon, it might make sense to generate some capital gains before year-end. But the potential for AMT should be explored. This occurs when certain tax “advantages” – such as the claiming of taxable capital gains or carrying charges on certain investments – exceed a $40,000 threshold. Note that capital gains on gifts to qualified donees are excluded.
The potential for AMT also occurs when large amounts of dividends are reported, resulting in a large dividend tax credit. Also at risk of the AMT are executives who qualify for a security options deduction, taxpayers claiming losses created with capital cost allowance claims on a partnership rental property, or a limited partnership loss from a tax shelter or from resource properties.
If the AMT is payable, it will offset regular taxes over the next seven years, so it’s important to keep track of these carry-forward balances, too.
5. Transfer high-value securities to an investor’s favourite charity
This strategy is a legal double-dip: no taxes are paid on the capital gains and a donations tax credit is claimable for the value of the transfer. Strategic philanthropy is not only tax-smart at year-end, but can serve to open more complex discussions about creating or updating a will, business succession planning and family estate planning.
Tax planning is the driver, but an intact legacy is the outcome.
Evelyn Jacks is president of Knowledge Bureau Inc. and author of Essential Tax Facts 2019: How to Make the Right Tax Moves and Be Audit-Proof, Too. Follow her on Twitter: @evelynjacks.