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Even More Wills, Chills and Thrills – A Few More Things to Consider When Drafting a Will

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During these times of turmoil and Covidic confusion, many of my clients have had Wills on the brain. Although many Wills do a good job covering off the basics, I still often finish reviewing my new clients’ old Wills with a vaguely uneasy feeling that there are a few too many “what ifs” left floating in the wind for my liking. And when I also reviewing their beneficiary designations, I really start to get fidgety. Thus, in effort to stop my squirming, I am inflicting this article upon you today.

In law school, I was trained imagine the worst and to make you think about things that you don’t like talking about at cocktail parties. Fortunately, my job is also to provide you with safety valves and solutions to protect you and yours if the worst actually does come to pass. Admittedly, in many cases, this extra worrying will be unnecessary and any extra issues, tension and confusion left unresolved will eventually work itself out with few permanent scars. On the other hand, if life does come up snake eyes, a little extra planning can easily pay for itself many, many times over in terms of problems avoided, relationships preserved, and dollars saved. In my view, when you’re talking about the transfer of a lifetime’s worth of hard work, sacrifice and saving to the people and causes you love most in amounts that can profoundly their futures, this is one of those times when it’s worth sweating the small stuff. 

Noting all of this, here are a few of the extra things I suggest considering before you sign your Will’s back page:

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  • Not being able or getting around to update your Will and beneficiary designations on insurance or registered plans in the future. I am particularly thinking of clients who lose their capacity to make legal decisions due to disease or injury but may linger for many years after diagnosis or mishap.  Most people assume that they can just make changes to their plans if someone dies in the wrong order or life throws a curveball, but this isn’t always possible. To counter this contingency, I like to include:
  • Backup guardians and trustees and perhaps secondary backups.
  • Indexing cash gifts to inflation or making them a percentage of the estate instead so that they keep up with inflation or grow/ shrink with the size of your estate if it is larger or much smaller than anticipated.
  • Distributing assets like accounts, real estate and company shares as part of an heir’s share of the estate rather than a stand-alone gift. In other words, if the goal is to equally divide an estate amongst your 3 children but for your youngest son is to get the cabin, divide your estate evenly but specify that your son’s share includes the fair market of the cabin at death net of taxes. In that way, regardless of what the cabin is worth in the future, your boy still gets his mancave but the estate is divided equally. Worried about the cabin being worth more than his fair share? Either he can get a mortgage to buy out his sibs at death or you can provide other options in your Will like him paying out his siblings over time at an interest rate that is based on the market rate at that time.
  • Contingency planning for life insurance and registered plans if leaving these assets jointly to your children with descendants of their own or who might have them in the future. Without this planning, if a child with descendants predeceases you, it is very likely that your other children would just get a larger piece of the pie and the children of the deceased would both go hungry and might even be stuck indirectly paying for some of the taxes on some registered plans they never received. Although many clients accurately assume that children who receive this extra share would do right by their nieces and nephews:
  • Some of your kids may honestly believe that they are just following your wishes when keeping the extra share or may never understand that there has been an injustice in the first place;
  • If the recipient children have creditor issues or incapacitated, they might not be able to set things right even if they want to; and
  • If the grandchildren are still minors or even young adults, it could be messy and complicated to determine how to get the money back to the children, avoid unnecessary taxation and determine who is to manage the money in the meantime.
  • Including provisions to hold an inheritance in trust if your now-healthy heirs are incapacitated at the time they inherit or perhaps beset by other problems, like creditor issues or addictions. Why take the chance that an inheritance might end up managed by the government, squandered, used to feed an addiction or handed over to creditors rather than your kith and kin?
  • Flexibility to move any trusts created in your Wills to other jurisdictions if your children or other heirs end up living abroad. It’s also really important to get good advice if you have heirs with U.S. citizenship or living in the U.S to avoid your heirs pay far more taxes than necessary.
  • Contemplating potential money issues and uncertainties might arise amongst your beneficiaries and trying to head off as many at the pass in advance. Along those lines, I suggest dealing with the following:
  • Stipulating executor fees and ongoing fees for trustees managing trusts for your heirs directly in the Will. Although courts generally award fees based on a percentage of your estate and you can do the same in your Wills, this can cause problems. Either the person doing the work doesn’t want to rock the boat and claim a fair (or any) executor fee or perhaps they does claim a fee and the rest of your heirs feel (perhaps with justification) that it is more than you would have wanted, particularly if the executor is also an heir and doing some of the work for their own benefit. The size of the estate doesn’t often match its complexity so naming a percentage in your Will might over or undercompensate your executor. Ultimately, although this is not a perfect solution, I have landed on picking a flat fee and indexing it to inflation or, if using a percentage, including a minimum or maximum value that is also inflation indexed. I also suggest doing the same thing for trustee fees as well in order to ensure that they also get paid yearly if required to manage trust funds for some of your heirs in an amount that is fair, transparent and not open to creative interpretation.
  • Including a memo that distributes your personal effects and then stipulating a way to divide the remainder, with provisions for compensation payments if there is a significant disparity in the value of the assets distributed. Some people fight more about the picture albums and artwork than the bank accounts. Trying to head this off at the pass in advance or even sitting down with your children to get clarity who gets what and agreeing upon a process for divvying up your “stuff” can go a long way to eliminating sour faces at future family picnics. Some people even put masking tape labels on the back of contentious possessions with the name of the future heir on the back! Others have an auction between heirs to buy your velvet Elvis print and bobblehead collection, although others think starting a bidding war over the family heirlooms and assets is just a recipe for disaster.
  • Providing guidance or perhaps including even a guardian fee for the people caring for your children. It is often exceedingly difficult to quantify the extra costs your guardians might incur raising your children and it can be an awkward conversation if the person managing their money and the person managing your children are not the same. Providing a statement of general principals to your trustee, such as to take a liberal and expansive view of expenses and to clarify things like including your guardian’s vacation costs when travelling, or to with your children might make your guardian and trustee’s relationship far more comfortable and productive. It is also a great idea to provide guidance on the sort of lifestyle you wish to provide your children. See my earlier articles on “Voices from Beyond the Grave” that discusses this and other related issues in more detail on either my or the Canadian Moneysaver websites for more details.
  • Considering whether the same person should be trustee and guardian. This is often done without incident, but there is a significant conflict of interest if the person deciding how much of the guardian’s mortgage, cable bills and property tax should be paid from the a child’s trust fund is the same person incurring these expenses. Every now and then, we lawyers hear cautionary tales about guardians who may have dipped into their charges’ trust funds a little too liberally, perhaps so that the children can’t afford to attend university or don’t have that down payment for their first home that mom and dad anticipated would be there.  This may be due to fraud or overly generous accounting, but it also might due to picking people to raise your children who are not also good at managing an investment portfolio or budgeting for the future. Moreover, both jobs require significant time commitments. Perhaps picking different people to watch your money than those you’ve picked to watch your kids is actually doing your guardians a rather large favour.
  • Not automatically picking children or spouses as executors or trustees. Being an executor is a generally thankless task and it takes longer to wind up many estates that most people expect. Although it can be expensive and not without problems, picking a professional trustee or at least someone who isn’t one of your heirs to do the job might sometimes be the best solution. Do consider the following before naming family as your executors:
  • Do your children get along and work well together if you pick them to act as a team? Do you want to include tie-breaker provisions in case they can’t agree? Does it make sense to name children who now live in distant lands or to require that they also sign off on every decision?
  • Will any children feel excluded if their siblings are picked as executors and they are not? As well, siblings not chosen may have unrealistic expectations regarding how long an estate should take to settle and have been noted to unfairly hound executors for their piece of the pie far sooner than is reasonable. The excluded siblings may also often feel without justification that the chosen child has not done a good job at maximizing the value of an estate or overpaid everyone involved, from the estate lawyer down to the woman hired to clean out your refrigerator after you’re gone.
  • Does your new spouse really want to be executor if it means your old kids are breathing down her neck? Conversely, how would your children from prior relationships feel if the new spouse is your sole executor or perhaps managing trust funds for them or their children? How do they feel about your spouse even managing his own trust fund if whatever is left at his goes to them,  particularly if that spouse has unlimited spending powers?  Likewise, if the children are managing your spouse’s trust fund and deciding both how much to pay out each month and how to invest the cash, how would your spouse feel about that?  If the kids are to get what’s left down the road, there is also a real temptation for them to both be cheap when budgeting money to your spouse while also picking riskier investments that focus more on growing their own future inheritance than the more conservative income-focused portfolio that better ensures your spouse will never run out of cash. The expression “conflict of interest” was perhaps invented with these situations in mind. The expression “family squabble” certainly was.
  • Is there even the slightest chance of a Will challenge, particularly if you have a blended family or you don’t treat your children equally in some provinces? An inheritance is a once in a lifetime windfall and no matter how people get along until that point, big money can still lead to big problems, particularly if you are not around to make sure that everyone plays nice. Moreover, if your children are forced to wait until your new spouse dies before getting their inheritance, they may actually get legal advice telling them to challenge your Will since they will have little chance of challenging their stepparent’s Will at a later date, assuming that there is anything left to challenge by that point anyway.
  • Is there a reasonable chance that anyone acting as trustees of any ongoing trusts will have to act as “bad cops” to their siblings, nieces or nephews and thus wreck Christmas dinners for decades to come or who will ultimately cave to pressure in order save future Christmases? This is another great reason to consider a professional trustee, particularly if dealing with heirs with potential addiction issues, creditor problems or a money management handicap.
  • Determining whether it makes sense to pass on or sell family assets like businesses and cabins. Will passing along these assets in kind to your family mean starting a new family feud rather than continuing a family legacy. Issues include:
  • Treating children with sweat equity in the business or farm fairly while also providing for your other children.
  • Balancing your business children’s desire to potentially run and grow the business vs. non-business children’s desire for cash flow and safety.
  • Do your children have the experience to run your business and to work together? Is this a recipe for success or the ingredients for creating a family disaster?
  • Who gets to make business decisions? Equal voices can mean gridlock or non-business children having too much say in matters they don’t understand but providing control to one can cause resentment or to make unfair or unpopular decisions. Who sets salaries for the business children? Are profits to be reinvested or a set percentage paid out each year? What if the child you pick isn’t up to the task and ultimately squanders not only his inheritance but his siblings’ as well by running the business into the ground?
  • What if any of the children wants to sell their share of the business or cabin and the others can’t or won’t buy them out?
  • Are your children able and willing to pay ongoing property expenses and do their share of the maintenance for family cabins and cottages?  If one child really doesn’t use the place as much, should they be paying the same portion of costs? Does that child really want the place?
  • Balancing financial autonomy with financial prudence.  Except for smaller gifts, I generally recommend holding a youngster’s share of an estate in trust until they are at least 25 years of age and often suggest handing over the inheritance to those children in stages so that they can learn and make mistakes with only a small portion of the inheritance before being entrusted with the big bucks later. Some of my Wills even require the children to co-manage their trusts with the original trustee for a while so that they get on-the-job experience managing investments, budgeting and taxes before getting to call their own shots. Although there are horror stories about younger heirs burning through their legacies and many years of their lives when trusted with too much too soon, I worry almost as much about responsible, well-intentioned kids hiring the wrong financial advisors or trying to do too much on their own with insufficient experience. On the other hand, in Wills that hold a child’s share of the estate until they are in their mid-30’s or so on, I usually draft the trusts in such a way that the money can be handed over ahead of schedule if the child has proven themselves along the way if the trust is no longer worth the expense. For trusts with a larger dollar value or time line, also consider appointing a “protector”. This gives your heirs someone to notify if the trustee is not up to scratch and the protector can swoop in, fire the incumbent and appoint a new trustee if appropriate. Otherwise, getting rid of a bad trustee is as hard and frustrating as getting ink stains out of your favourite shirt and far, far, far more expensive.
  • Decoupling family finances. While money is probably not the root of all evils, I do see it as a major cause of many family spitting matches. Accordingly, I ask my clients to carefully consider whether or not to leave assets like private companies and real estate jointly to multiple family members for the reasons expressed previously. In situations where it is the right decision or the only practical choice, I encourage clients to take additional steps, like signing agreements or at having family discussions in advance to set up ground rules, particularly to cover what would happen if one of the children later wanted out, such as a buyout procedure, valuation formula and the appropriate timeframe for payouts. Do investigate life insurance in these situations as well in the hopes of paying some of the children out in cash rather than making them get shares in the family business instead. You might even make the children to get the business or cabin pay for this insurance in the first place!
  • Providing surety in blended family situations. Decoupling finances can be even more important for blended families. For first marriages, it is common for the surviving spouse to inherit all or most of the family assets and that usually makes sense. In second marriages, however a lot can go wrong if the children from your first kick at the can are forced to wait to inherit until your second dearly beloved is no more. This can poison relationships, result in those Will challenges I mentioned earlier in places like B.C. and might even result in your children missing out on any part of your estate if your new spouse outlives them, remarries, goes on a decade long spending spree or ultimately leaves  their inheritance to their favourite charity, the pool boy or their own children instead of yours.  If it isn’t possible to provide for your children while also protecting the surviving spouse (again, more life insurance might be a solution in some cases), many families leave the survivor’s share in a trust that ensures that the remainder flows to the children or their descendants eventually. While this situation isn’t ideal, picking the right trustee and providing sufficient guidelines in the trust can at least go a long way to minimizing family tension, particularly if the children at least receive something at the first passing, perhaps when they need a financial leg up the most.
  • Equalizing inheritances for children with large age gaps. If you’ve already put some of your older children through school, covered their spring break adventures, paid for 10 years of interpretative dance or tuba lessons, funded a closet full of must-have jeans,  two decades worth of pizza and so on, is it fair to leave your estate equally to all your children when the younger ones never received such benefits? In situations like this, I often use a general education and maintenance trust to cover all expenses for anyone in school or under a set age, with the remainder divided equally amongst all of your children, regardless of age, when the last of them no longer qualifies for payments. This might comprise 40% of the estate if no surviving spouse and is designed to provide the younger children with the support and extras that their older siblings received during your lifetime. The remaining 60% would be equally divided amongst all the children, with older children receiving their portion of the 60% immediately. When the dust settles, all the children have been provided with the same leg up and luxuries prior to get their university diplomas or reach adulthood but your older children are not forced to wait until their youngest sibling gets a diploma before having the cash to buy their first home.
  • Including provisions to gift over an inheritance on a child’s death.  Although most Wills contemplate what happens if a child predeceases you, most don’t deal with what happens if a child inherits but passes on while leaving behind a spouse. In most cases, your son or daughter-in-law would likely inherit and your grandchildren would only what’s left after (s)he is also deceased. If that spouse remarries, has additional children in the future or squanders the cash, then your grandchildren may end up with nothing, less than you would like or perhaps inherit it far later in life than you would have wanted. Leaving the money in a trust that names your child and their own descendants as beneficiaries can ensure that your grandchildren get what’s left on your child’s passing or can even gift over to your other children instead at that time if none of these grandchildren exist and you really don’t like your son /daughter-in-law. As an added bonus, this type of trust structure can actually save your child a lot of money along the way in taxes avoided by allowing gains and income to be taxed in your grandchildren’s hands at their rates, making any inheritance go a lot further. You might even name your child to be their own trustee in some cases in order to maximize flexibility and decrease both complexity and costs of running the trust.

Conclusion

My job as a lawyer is to find the dark cloud hidden inside the silver lining, no matter how small and unlikely.  Although many of the extra provisions I’ve just enumerated in copious detail may be ultimately be unnecessary in many cases, the downside is generally just a few extra dollars and hours “wasted.”  On the other hand, taking a bit more time now to think and plan for the unpleasant and unthinkable might be a game changer.

A Stand Against Capital Punishment – Ways to Minimize Your Capital Gains Tax Bill Part 3 – More Advanced Strategies

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If you’re not full to bursting with ideas on how to save on capital gains tax after my first two servings in this feast of ideas, today’s offering will hopefully round things off nicely. Here are some more strategies that you can consider for minimizing your family’s capital gains bill.

  • Trigger and Use Capital Losses Strategically. Although some people call November and early December “autumn”, we financial types think of it as “tax loss selling season.” That’s when investors look to sell some of their losing investments to create a loss they can use to offset again capital gains they’ve earned that year and then either against any of the three prior years or against any future gains if any of the loss still remains. Here are some specific things to keep in mind when doing this: 
    • The “superficial loss rules” prevent you from claiming your loss if you or your spouse buys back the same stock or fund within 30 days before or after buying or selling your loser. It also catches you if either of you buys back those stocks in a different account, such as an RRSP or TFSA,  or even in a trust or corporation you or your spouse control. Moreover, if repurchasing in a registered account, the outcome is even worse. It means losing your right to claim that loss forever, as you cannot claim your loss now and you don’t generate gains or losses inside of registered accounts, which means you won’t get to claim it later, either. Accordingly, if you still like the investment’s long-term prospects but want to trigger a loss now, consider waiting and re-buying after the deadline expires or buy a similar but not identical stock or fund asap if you’re not willing to wait.
    • Sometimes it is possible to have the superficial loss rules work for rather than against you, such as when a spouse with no capital gains or in a lower tax bracket is the one that owns the loser investments.  If the high-income spouse buys that same dog stock within 30 days before or after the low-income spouse sells it and then waits a full 30 days after that point before selling herself, then the high-income spouse will be able to claim the capital loss.

Here is a quick example of this: Jack owns a stock in his non-registered account worth $10,000 which he bought for $25,000 and is in a far lower tax bracket than Jill, who has some big capital gains to report that year. If Jack sells his stock on April 1 and Jill buys that same stock in her non-registered account on April 2 and then sells it herself on May 5, then she will be able to report a capital loss of about $15,000 on her tax return, although Jack won’t be able to do the same.

    • Consider tax loss selling for its own sake when you have big losses on the books and have similar stocks or investments you could purchase with the sales proceeds yearly. Even you don’t have any immediate capital gains to realize down the road, it’s nice to lock in some of your capital losses when you get a chance and if doing so makes investment sense. Having losses on the books gives you more flexibility in the future, such as allowing you to re-balance your accounts without triggering gains, can also mean avoiding big tax bills in years you’re in higher tax brackets. If you still love the stock, then there is nothing to stop you from buying it back so long as you stay clear of the superficial loss rules.
    • You have no choice if you have capital gains already earned that year when realizing losses – you have to first apply the losses against that year’s gains. Accordingly, be careful about your timing when selling winners or losers if your ultimate goal is to apply the loss against gains you’ve earned in past years or expect to earn in the future. For example, if expecting to sell a rental property at a big gain next year and this might push you into the highest tax bracket, either avoid selling your losers until next year or be sure not to trigger capital gains this year that would use up those losses.

Here is a quick example of some potential savings. Assume an investor with $80,000 in taxable income, including a $40,000 capital gain (i.e. $20,000 in taxable gains), has the choice to offset that gain this year by applying unused losses from the past or selling an investment with a $40,000 capital loss or triggering / applying that loss next year when he is planning to sell his rental property when his total taxable income, including $200,000 in taxable capital gains (i.e. $400,000 in total gains) is expected to be $250,000.

Scenario

Total Income   Total Income  

Net of Loss

Tax Saving from

Applying Loss

Loss claimed in 2019 $80,000 $60,000 $5,640
Loss claimed in 2020 $250,000 $230,000 $9,960

Thus, by waiting until 2020 to apply the capital loss, this canny investor has about 77% more money to spend on nice dinners out.

    • Check to see if you have unused capital dividend credits on your small business before triggering capital losses. Capital dividends are dollars your company can pay out to you tax-free and represent the 50% of previously realized capital gains that weren’t taxed corporately. Unfortunately, if you haven’t already used up that room, 50% of future losses can reduce the amount of money you would have otherwise been able to pay out tax-free. Thus, do declare and pay out your capital dividends every year, even if you keep the money invested corporately so you don’t end up with egg on your face in the future when reporting future capital losses. 

 

  • Donate and Repurchase Your Stock Market Darlings Instead of Gifting Cash. As I explained in my recent articles on charitable gifting, if you donate appreciated stocks, the government forgives your capital gain but still gives you credit for donating an amount equal to the stock’s value at the time of the gift. If you love the stock, there is nothing that stops you from repurchasing the stock using the cash you would have otherwise donated instead. Thus, the charity gets the same gift you originally intended, you still own the same amount of your favourite stock, but the prior capital gain on that stock has now been erased. See my previous articles on personal and corporate donation to learn more about this strategy and how to use it most effectively, particularly when deciding whether to gift personally or corporately.

 

  • Pick the Right Person to Own the Right Investments.  As illustrated in some of the examples I’ve laid out in this series, there is a lot of money to be saved when gains are realized when you’re in lower tax brackets. One simple way of saving is having the lower income spouse own the investments with the bigger upside if (s)he is likely to be in that bracket for some time to come. If that spouse doesn’t have as much money to invest, consider having the higher income spouse pay more of the family bills so that the lower income spouse has the money to invest in that stock or real estate purchase that you’re sure will double in 5 years. In some cases, the right person may not be a person at all, but a trust that names both spouses and all your dependents that you control. As I’ve done with some of my clients, the wealthier spouse loans money to the trust at the prescribed government rate (currently 2%). Each year, you can decide how to distribute income and gains from the trust amongst everyone you’ve named as a beneficiary. If that includes minor children, university students not earning a significant income, or even older children that are in tax brackets a lot lower than yours, there is a lot of money to be saved. Although the lender has to declare that loan interest each year for tax purposes, which does have to be taken into account when crunching the numbers to make sure this is right for you, the trust does at least get to write off the interest. I’ve written about these trusts previously if you want to check out my website or comb the Canadian Moneysaver archives.

Finally, those of you with minor children can also consider setting up in-trust accounts for your young ones. Regardless of their age, all capital gains will be taxed in their names not yours, although dividends and interest would be taxed in the name of the person funding the in-trust account in most cases, with a few exceptions. Be careful when considering this option, however, as once the money is in an in-trust account, it belongs to the child. Once (s)he reaches the age of majority in their province of residence, (s)he can ask for the money with no strings attached!

  • Own the Right Investments in the Right Account.  Not only is there money to be saved when lower income family members are the ones triggering those big capital gains, there is more tax to be avoided if those gains are held in the right account! Unfortunately, many Canadians use their Tax-Free Savings Accounts as “high” interest savings accounts that perhaps pay 3% interest if the stars align just so. Instead, consider holding your investments with the biggest upside inside your TFSA and your “high” interest savings accounts on the outside looking in. Although you will have to pay tax each year on your token interest, this can be more than worth the sacrifice if it saves you mountains of capital gains tax if your TFSA investments pan out.  Just be aware that if they don’t, you won’t be able to write off the losses against capital gains.

Secondly, realize that any gains inside your RRSP will be 100% taxed upon withdrawal.  Thus, it might make sense to have more of your tax efficient investments, like those that pay eligible dividends and produce capital gains owned in your non-registered accounts and more of the interest-payers inside your RRSP. Although you should consider keeping the same overall investment allocation, you could essentially swap capital gains payers in your RRSPs or RRIFs for interest payers in your open accounts, although this is not a universal rule.

Thirdly, as I’ve written about before, it might make sense for some of us to pull money from RRSPs or RRIFs before we need it if we’re in low tax brackets and invest it in a TFSA or, if you have no room, your open account. Although you won’t have as much money to invest and compound than if you’d left your money in your RRSP, only 50% of your future gains will now be taxed and any eligible dividends you receive will now qualify for the dividend tax credit. There are a lot of things to consider when deciding whether to pull money out of your RRSP or RRIF ahead of schedule, so I recommend getting detailed planning advise before taking this step.

  • Sometimes, the best answer is to delay, delay, delay.  In some situations, procrastination is a good thing, as is sometimes the case in the world of capital gains planning. Although most of us shudder at the thought of the size of our potential tax bills at death, it might be a better choice in some instances than paying the piper ahead of schedule even at lower rates. There are a lot of moving parts in this calculation, such as how big a gain you’re facing, how long you expect to live (and ultimately pay tax at death) and the difference between your current tax rate and what you’d likely be paying at the time you’re scheduled to meet with the grim reaper. By paying tax early, you will have less money to compound going forward. Accordingly, you’ll also want to look at the expected rate of growth on your investment, too, as the higher the rate of return, the higher the opportunity cost of selling early.

The following example assumes a retiree who thinks he has 10 years to live is considering triggering a $100,000 capital gain ($50,000 of which is taxed) on a stock he originally purchased for $20,000 which averages 7% growth per year. I’ll assume it doesn’t earn any dividends. His taxable income is $115,000 that year excluding the capital gain. Alternatively, he could wait until death to sell that investment, at which time he expects to have a taxable income from all sources of over $1,000,000, which places him well within the highest tax bracket.

Scenario

Total Income  Inc. Gain

After-tax Portfolio at death Net of Tax

Sell Now $165,000 $170,725
Sell at Death $1,000,000 + $182,260

 

Of course, when making this decision, the investor should also look beyond just tax to include important investment considerations, such as an over-concentration in one stock, his overall portfolio mix and expectations for the stock going forward. It could still be the wise move to sell off at least some of this position ahead of schedule despite tax considerations.

Conclusion

A sometimes-forgotten component of good investing is tax planning – figuring out how to minimize the portion of the capital gains the government takes off the table when you decide to cash in your chips and pocket some of your stock market winnings. Although it is important to ensure that you don’t let good tax planning lead to bad investment decisions – sometimes, any way you slice it, the right time to buy or sell means paying a bloated tax bill – it is also a mistake not to consider tax when making any investment decision. It’s a lot like failing to read the whole menu before ordering at a new restaurant – although you might end up making a good choice, you might have missed out on making a great one.

 

A Stand Against Capital Punishment – Ways to Minimize Your Capital Gains Tax Bill Part 2 – Advanced Strategies

In my first article in this series, I have hopefully whetted your appetite for ways to have your cake and eat it, too. In other words, how to best combine large capital gains with small tax bills. Today’s missive is about putting the principles laid out in that earlier article into action.

Advanced Strategies

The following suggestions will apply some of the points noted above, and, as the cherry on top, I’ll throw a few more crumbles on the table as we go that can result in even more savings:

  • Realize Gains in Your Non-Registered Accounts Strategically. Although it can be dangerous to hold onto your investments too long in some cases, as years’ worth of gains can sometimes collapse like a hot souffle in a cold kitchen when a good stock goes bad, waiting to sell when in the right tax bracket can also save a lot of tax dollars if the stars and Wall Street both align. For clients holding rental properties or large equity positions, that might mean waiting to sell until retirement or during a sabbatical year when in lower tax brackets. My example from the first article in this series illustrates the potential savings of selling when in a lower tax bracket. You might also sell off only part of an asset in a single tax year.  Assume an investor receiving full OAS who typically earns $65,000 in other income wants to liquidate a stock with an $80,000 capital gain. The following shows her tax bill if she sells it all at the end of 2019 or if she sells 50% on the last trading day of the year and the remainder on the first trading day of 2020, assuming the price and tax rates don’t change. As tax brackets are indexed, this investor might actually save a bit more by using this strategy than this example illustrates.

Scenario                      Total Gain       Taxable Gain  Total Income   Tax Bill on Cap Gain 

Single Year Sale           $80,000             $40,000              $105,000            $15,751

Split Year Sale              $40,000 / yr     $20,000 / yr        $85,000 / yr       $13,904 (combined)

By waiting one trading day to sell the remaining 50% of her shares, this investor could save as much as $1,847, including the OAS clawback amount. Some investors might even stagger the sale over 3 years to have more of the gains taxed in even lower brackets. Just keep in mind my souffle metaphor from earlier when trying to get too clever about picking the time to sell – I don’t want you getting egg on your face by holding the stock just a little bit too long and watching your capital gain turn into a capital pain.

  • Realize your Company’s Capital Gains Strategically, too.To begin, consider whether your company’s total taxable passive income for that year will exceed $50,000 (remember – only 50% of capital gains are included as passive income, which means you can earn twice as many cap gains than interest and investment dividends inside your company for this calculation) and by how much. The federal government and most provinces give a preferred tax rate on the first $500,000 of active business income per year, with this threshold reduced by $5 for every $1 your company’s passive income from the previous year exceeds $50,000. After estimating that year’s taxable investment income, then determine how much business income you expect to make and keep in the company next year. If you don’t plan on keeping any excess earnings in the corporation or if that money would still qualify for the small business rate, then no big deal. On the other hand, if triggering too many gains might impact your company’s active business tax bill in the year to come, then decide whether or not it still makes sense to sell or see if there are any capital losses you can apply or create to reduce the taxable gain.

Conversely, if you will have already lost your small business rate next year (i.e. you’re going to have more than $150,000 in passive income this year regardless of what you do), consider turning lemons into lemon tarts by triggering additional capital gains now. By gorging yourself on capital gains this year, you might find it easier to stay under the $50,000 threshold in the future.   This works best if you have a legitimate need to re-balance your portfolio anyway or where planning on realizing the gains over the next year or two in any event, as triggering tax bills earlier than necessary means having less money to compound going forward. You would have to compare the future tax savings to the lost growth and income on the money you’re paying to the government ahead of schedule in taxes. Ultimately, since there are a lot of factors to consider, including how much realizing extra gains now might impact your personal income, the decision when to trigger corporate capital gains is usually best made with the help of your accountant or an experienced financial planner.

  • Consider Investing for Capital Gains Corporately to Protect an Active Company’s Small Business Tax Rate. My last bullet explains how too much passive income inside one of your companies can increase the tax rate you pay on active business income the following year and leave you with that queasy feeling that often follows dinner at a smorgasbord.  In addition to strategically realizing gains and losses inside your company, consider whether it makes sense to focus on capital gains investments inside your company in the first place if the passive income rules are cramping your lifestyle, as well as your stomach. Only 50% of the gains are included in the passive income calculations and you can control when you trigger those tax bills when you own individual stocks or sell ETFs or funds (although you still might receive some gains from funds and ETFs along the way.) This might work even better with investments like corporate class mutual funds (if you can stomach the fees and they still work for you after the recent tax changes that can impact their tax efficiency) that are designed to minimize taxable distributions or REITs (real estate income trusts) that generally pay tax-free return of capital in full or in part up until the time of sale. As an added bonus, your company can pay you the 50% of the total gain that wasn’t corporately taxed to you as a tax-free corporate dividend, which gets more money in your pocket without having to flow out more taxable income to you.

 

  • Use your RRSP Room Strategically.  If you’re normally in a lower tax bracket but are expecting a super big gulp-sized capital gains in the future that will push you to the tax bracket stratosphere, consider stockpiling your unused RRSP room and using it when it is time to sell. As only 50% of any gains are included as income, $50,000,000 of unused RRSP room can offset $100,000 of realized capital gains. Also, keep in mind that your RRSP contribution doesn’t have to be a long-term commitment – you can pull a bunch of the money out during the next tax year when in a lower tax bracket if you want. Have a spouse in a lower tax bracket or who might be in the future, such as if you retire in different year? Consider making the contribution a spousal one, although keep in mind that the money needs to stay in your spouse’s RRSP for at least 3 December 31’s before withdrawals can be taxed in your spouse’s hands.

Here is an example to show some of the potential savings. Assume you earn $100,000 per year net of all other deductions and make an $18,000 RRSP contribution by the end of February 2020. You have the choice of deducting your contribution for the 2019 tax year or deducting it for the 2020 year (or later, if you really wanted), as you are expecting to sell rental property with $300,000 in unrealized capital gains ($150,000 of which will be taxed) in the near future. Although you will have to wait an extra year to get your refund, here are the potential tax savings you might reap by practicing delayed gratification.

Scenario                      Total Income          RRSP Tax Refund

2019 deduction           $100,000                   $5,958

2020 deduction           $250,000                   $8,964

By waiting a year to apply her RRSP deduction, this investor saved about $3,000. Although she did lose the use of her refund dollars for 365 days, she would have needed to get an after-tax return of over 50% if getting the smaller refund sooner to make it worth her while. This investor would also definitely want to make her regular RRSP contribution in 2020, as she would have earned about $18,000 more in new room based on her 2019 income, as this additional deduction would produce a similar tax refund.

  • Consider Delaying your OAS Pension if Triggering Gains in your Late 60’s. Consider delaying your CPP as well. At this point, if your taxable income exceeds about $76,000 and you are on OAS pension, you will lose fifteen cents per dollar your taxable income exceeds this amount. Since only 50% of capital gains are taxed, think of any capital gain that takes you into the clawback zone as costing you seven and a half cents instead. Actually, it will cost you less than that as well, since you would have had to pay tax on those lost pennies and dollars in OAS pension anyway. Since you can control when you start your government pensions and are rewarded for waiting by getting an increased pension, consider delaying at least your OAS pension if you are planning on triggering a big capital gain in your late 60’s until the year after the dust has settled. This gain may have cost you your entire OAS pension for the year of sale anyway, so you really haven’t lost anything by waiting, although still get a larger pension for life. To me, it’s like trading in a kale salad for a chocolate brownie or swapping something that I won’t touch anyway for something even better down the road.
  • Consider Claiming a Capital Gains Reserve When Selling Real Estate. It’s a lot easier to spread out the capital gains hit when selling RBC shares rather than a studio apartment on Howe Street. On the other hand, there is a special rule that applies if you don’t receive your real estate or business sales proceeds in single year. In fact, if you defer enough of your gain, you can spread the tax hit out over up to 5 years. It usually means taking back a mortgage when you sell, which is admittedly something that doesn’t work for a lot of us. If selling in December, at least consider structuring the deal so that the gain is spread over 2 years rather than just one by delaying payment of part of your sales proceeds until January. If you and a spouse own real estate jointly and you don’t plan on selling for a few years, it might even be possible use this strategy between spouses before selling to an outsider. One spouse sells his interest to the other but gets paid (and taxed) over the next 5 years in 20% increments, charging his spouse interest at the minimum allowable rate during the interim. Although the buying spouse still has to pay tax on her gain plus the increase in value on the portion she acquired from her husband, the total tax bill might still be a lot less than if the selling spouse had to also include his part of the gain in a single tax year.  This is another strategy to discuss with a tax or planning pro in advance, as there are a few moving parts involved.

 Conclusion

Hopefully, some of the ideas described in this article have provided you with plenty of food for thought. If so, stay tuned until next time when I serve up the final course.

A Stand Against Capital Punishment – Ways to Minimize Your Capital Gains Tax Bill Part 1 – Basic Principles

 

When the rubber hits the road and it’s time to sell your investments, all that really matters is what you have left after tipping the tax man, regardless of whether your goal is to fund a once-in-a-lifetime trip, buy your first home or merely pay for groceries. After all the hard work of saving in the first place, managing your investments and minimizing excess fees along the way, failing to do proper tax planning is like forgetting to serve whip cream with pumpkin pie – not a disaster, but still enough of a setback to cause some mild discontent and feelings of what could have been.  Adding sound tax planning on top of a great investment strategy is the icing on the cake that can make a big difference to your after-tax rate of return. This is part 1 in a three part series designed to do just that. Today’s offering focused on the basic principles you’ll need to know when doing capital gains planning. As always, all calculations use B.C. tax rates from the current year (2019).

The Basics

At the risk of stretching my food analogies to the breaking point, some of these ideas may not be a piece of cake to understand but putting in the time now might one day save you a lot of bread. To begin, it’s important to understand exactly how capital gains are taxed. The basics are as follows:

  • Only 50% of your total gain, net of expenses is added to your taxable income. This usually means paying at least half as much tax per dollar of capital gain compared to interest dollars. This is also true when investing inside a company.
  • Since only 50% of your total net gain is added to the mix, this means that you can earn a lot more capital gains in a set tax bracket before getting pushed into higher brackets. For example, assume an investor earns $50,000 in either interest, eligible dividends, or capital gains and $60,000 in net income from all other sources. Only 50% of the capital gains are taxed but eligible dividends are “grossed up” by 138% of their actual payment. Thus, the following chart shows how this hypothetical fifty grand will show up on your tax return for calculating your tax bill and what your total taxable income and marginal tax rate would be when this money is added to $60,000 in other income.                      

Type of Income       Taxable Amount      Total Income             Marginal Tax Rate*

Interest                     $50,000                       $110,000                     38.29%

Eligible Dividends  $64,000                       $124, 000                    40.7%

Cap Gains                 $25,000                       $85,000                       31.0%

*This column lists the combined Federal and B.C. tax bracket that this taxpayer would inhabit on his last dollar of total income. It DOES NOT show the actual tax rate (s)he would pay on that dollar if it was dividends or capital gains, even though it does provide this information for interest. For capital gains, (s)he would pay 15.5% on that last dollar and for eligible dividends, (s) he would pay 18.88%, ignoring any OAS clawback.

  • Capital gains are only taxed when the investment is realized or sold, unlike interest or dividends, which are taxed yearly upon receipt. That means that more of your money is left to compound most of the time when compared to other sources of taxable income, except if receiving dividends in the lower tax brackets, where the payments may be free or even better. Of course, as Moneysaver readers know so well, these dividend payments generally go along with investments that are also realizing capital gains anyway, which is like ordering a pie and getting the ice cream on the side for free.
  • You can often control when your capital gains bill is triggered, such as when selling rental property or those Tim Horton’s shares you’ve been sitting on for years. That means triggering your gains strategically can reduce how much tax you pay on your capital gain. For example, assume you have the choice of selling your rental property, which has an unrealized capital gain of $400,000 on December 31stin a year where you’re earning $110,000 in other income and one day later, after you’ve retired and expect to earn only $30,000 that year from other sources. Here is what your tax bill on the gains looks like in both scenarios:

Sale Date     Total Cap Gain      Taxed Gain     Total Income   Tax on Gain                                                                                                                  

Dec 31            $400,000                   $200,000           $310,000            $93,449

Jan 1               $400,000                   $200,000           $230,000            $76,956

But what if this investor owned the property jointly with their spouse who was also making $30,000 and they both sold on Jan 1? In that case, their combined tax bill plummeted to $62,802!

  • You can apply 50% of any capital losses you’ve realized in the past but not yet written off against gains you realize that year. If realizing any losses this year, after offsetting them against that year’s gains, you can carry them back against gains you’ve earned in the 3 prior years or carry them forward indefinitely to use against future gains or against other income if any are still on the books at your death.
  • When selling only some of a fund or individual stock in a non-registered account, while hanging onto some until later, the tax bill gets calculated by averaging all of your purchases of that asset so that you are taxed proportionately, rather than looking at each sale or purchase individually. Thus, if you sell 40% of your shares in a restaurant fund in your non-registered account, you would include 40% of the total gain of all the shares you own, regardless of when you purchased them.
  • Capital gains inside your RRSP and RRIF are like all your other RRSP and RRIF investments – taxed as income only upon withdrawal or death. Capital gains inside your TFSA are tax-free in all instances, just like any other type of income earned inside that account. That means there are no special rules for capital gains in these instances. If transferring shares you own in your non-registered account to a registered account, you trigger capital gains at that time as if you’d sold the shares instead. It is often a bad idea to transfer shares with losses to these accounts in kind, as you won’t get credit for the capital loss. Instead, consider selling the assets and either waiting 31 days to repurchase them in your registered account (or your spouse’s name or so on) or buy a similar but not identical investment inside your registered accounts if the capital loss is large enough. I talk more about this more in my later articles when discussing the “superficial loss rules.”

Conclusion

Today’s article is merely the appetizer for the far more sumptuous main course where you can put some of these principles into action.