Tax Planning – When Procrastinating Can Actually be a Good Thing – Part One
Happy New Year! May 2013 be full of happiness, joy and opportunity. Since Januaries are traditionally about making and following through on resolutions, I thought I would fly in the face of tradition and talk about a time when you might actually benefit by putting something off until the future – paying taxes.
I have already written one article on how to minimize taxes by income splitting with low income spouses or adult children. This time, I want to talk about how you can reduce your tax bill by either putting off your day of reckoning or by taking your tax medicine a bit at a time rather than all at once. In other words, let’s talk about healthy procrastination, as well as strategically timing when to trigger tax bills and the potential savings these steps can reap.
To begin, I am not suggesting burying your head in the sand and hoping things will work out right in the end. Instead, I am talking about strategically and creatively using our tax system and your expectations of your future taxable income in order to put more money in your pocket. This also involves structuring your financial affairs in such a way that you can take advantage of these future opportunities.
To expand on this topic, I first want to review our tax system so you can identify why these opportunities exist. I will talk about specific steps you can take to benefit from our system in a later article. As most people know, Canadians pay tax at progressive rates. As I’ve said in previous articles, this does not mean that the people setting these rates are particularly enlightened or ‘with it’. Instead, it merely means that each time your total taxable income exceeds a set amount, you will be charged a higher tax rate on any subsequent income you earn. In B.C., there are about 10 different tiers and corresponding tax rates for income earned inside each tier known as tax brackets. The lowest is $0 and the highest is 43.7%.
Noting the vast number of different tax brackets and the wide range of different tax rates, the tax savings opportunity comes from trying to structure your affairs so that as much of your income as possible is taxed at the lowest rate possible. I have already talked about income-splitting with other family members to take advantage of their lower rates. Today, it’s time to look at income-splitting with yourself – putting off when you declare income and must pay taxes on it as long as possible when you are already in a high tax bracket and trying to realize this income down the road when you won’t be taxed as heavily on it. For many of us, this may mean during retirement, when we are no longer earning a salary or perhaps to a time when we are taking time out of the workforce, such as during a sabbatical year or you plan on staying home to be full-time parent or caregiver.
In other cases, such as when selling larger assets that incur capital gains, like real estate other than your home, a business or an investment portfolio, it might also make sense to try to spread the tax hit over several years rather than biting the bullet all at once. For example, a savvy businessperson might not only put off selling a rental property until the year after s/he retires and is in a lower tax bracket; s/he might also arrange to receive the sales proceeds in such a way that the capital gain will be spread out over 5 years rather than all at once if would otherwise mean having a lot of the taxable capital gain taxed at the highest rate. Our tax system allows us to do this through something called a capital gains reserve, which I will talk about in a later article.
In addition to hopefully paying less tax later by riding the good ship procrastination, there is another potential advantage. Besides having a smaller total tax bill, you also have the use of the money that you would have otherwise had to forward to Revenue Canada in the meantime. Put another way, even if your total tax bill would otherwise be the same if you triggered a tax bill 10 years later rather than right now, you would still be ahead of the game because you had an extra 10 years to use the money you have to pay for taxes for other purposes, like paying down a mortgage or investing. You would be ahead by the interest you save on by applying the money you would otherwise pay in taxes towards personal debt instead or the after-tax profits you make over the 10 years if you put the money into the stock market, even if you had to reborrow the money or cash in your investment 10 years later to pay the deferred tax bill. In other words, even if the tax bill is ultimately for the same amount, you can still be ahead of the game if can push your day of reckoning far into the future.
On the other hand, sometimes it does make sense to pay the piper sooner rather than later. For example, many retirees may want to withdraw more money from their RRSPs and RRIFs than they actually need if they can get the money out at lower tax rates than would be the case if they waited until the last possible moment (or death). Even though they lose the use of the money used to pay taxes sooner than necessary, this still might lead to a better result if there are big enough tax savings right away; for example, they may wish to lower their ultimate tax bill by 30% by paying early based on the assumption that delaying the day of reckoning and having the use of their money for a few more years still won’t add up to the same benefit they’d receive by triggering their tax bill now. Triggering the tax bill earlier might also be more palatable if the balance of the extra money withdrawn ahead of schedule net of taxes won’t be taxed as heavily going forward than if it stayed inside the RRSP, such as if put into a TFSA or used to pay down debt. Put another way, deferring the tax bill may not be as attractive if any growth on the original investment between now and them will be taxed as income while the smaller amount left over after triggering a tax bill early can be put into more tax-efficient investments or applied towards non-deductible debt, where the ‘rate of return’ is the interest saved and this ‘return’ is not reduced by taxes.
As well, many seniors start frothing at the mouth upon the mere mention of the OAS clawback, which Ottawa refers to by warmer and fuzzier term of ‘recapture.’ Foresighted seniors may try to avoid the clawback by withdrawing money from RRSPs before they turn 65 and their OAS pensions start. Likewise, a retired couple not currently subject to clawback may withdraw more RRIF money than they actually need now if they are worried about the surviving spouse suffering clawback and / or paying taxes at a higher marginal rates when all of income currently split over two tax returns must be taxed solely in the survivor’s hands at a rate high enough to invoke the clawback. As a final OAS planning point, Canadians turning 65 in 2013 and onward now have the chance to defer the start of their pension for up to 5 years in exchange for a .6% increase per month (7.2% per year) to their monthly entitlement. Accordingly, if you will still have a high taxable income when you turn 65, such as if you are planning on working for a few more years or if you plan on triggering big capital gains bills around then, consider delaying your OAS until a tax year where your income is low enough that you will actually be able to keep most of it.
On a similar note, you might use the same principals when deciding to start your CPP retirement pension early (i.e. between 60 and 65), at the normal retirement age of 65 or to delay it until as late as your 70th birthday. Although there is no clawback to CPP pensions, the extra tax you may pay if you are in a high tax bracket at that time, the incentives for delaying the start and the penalties for starting it early may influence when you start collecting this benefit. Although there are many more considerations to take into account, I will leave further discussion on this point until a later article.
In any event, in summary, good tax planning involves strategically triggering tax bills in years where you have a lower taxable income as well as recognizing that the longer you have the money you would have otherwise had to pay in taxes, the better off you will be unless there are significant tax savings from triggering the bill ahead of schedule. That’s it for now. My next article will address some of the steps you can take to arrange your financial affairs so you have more opportunities to take advantage of these steps. In the meantime, I hope your new year is off to a good start and may 2013 be a wonderful year.