Knowing More about the Company You Keep: Learning How Small Businesses Are Taxed So You Can Plan and Invest Intelligently

Part One – Taxation of Active Business Income, Dividends and Integration Theory

A lot of financial planning is learning how to move your pieces effectively around the chessboard of life in order to get the best possible outcome. This is particularly so when doing tax planning – by merely rearranging who owns what and how they use it can have a profound affect on a family’s overall tax bill. As I like to repeat so often that it’s become a mantra: it’s not what you make, but what you keep after appeasing the tax man is what matters.  And, when clients get sick of hearing this, I then tell them that no one cares more about your money that you do – no matter who’s helping you, the more you know yourself the better off you’ll be. Today’s article speaks to both of those maxims.

In particular, I want to talk about how small private companies, aka “Canadian-Controlled Private Companies” or “CCPCs” are taxed. The tax rules for CCPCs are not simple and seem to be written in a tongue not known to common man. Accordingly, when I start working with new clients, many of them are either paying more tax than is necessary right now or will overpay in taxes in the future because they don’t know the rules, have not got the necessary advice from their other advisors and have not planned 10 or 20 years down the road. Moreover, even if they have received good advice at some point, life and the law both change. Thus, yesterday’s pearls of wisdom may no longer apply to today’s realities. This is particularly true in light of the changes imposed on small business owners by the current federal government since last July that are either now in effect or coming soon.

With all of this in mind, this article, and those to follow, are designed to outline some of the basic principles of corporate taxation in (more or less) simple English so anyone taking the time to muddle through will be able to make better tax decisions going forward, ask better questions of their professional advisors and hopefully, sleep better at night by having more control over their own situation. Accordingly, pour a good cup of coffee, or perhaps something even stronger, and let’s begin.

Integration Theory and How It Works When Earning Active Business Income

Why small businesses are taxed as they are comes down to something that tax types call “integration theory.” Although it sounds like something from the civil rights movement of the American 60’s, it’s a really far less exciting and involves far more math. The basic premise is that a businessperson running a sole proprietorship (I’ll call him “Jack”) and someone running the same business inside a company (why not call her “Jill”) should pay about the same amount of tax on the profits they use to support their families and spend on exotic vacations abroad. Tax rates and policy are designed to achieve this result. For this article, I’ll use exclusively B.C. personal and corporate tax rates.

One of the main differences between Jack and Jill is that Jack is taxed completely in his own name on all business income. He will have a lot more deductions since he is a business owner than someone who is an employee, but all his income will be taxed in most cases in the year that it is earned based on his level of income and marginal tax rates. In other words, if he earns a lot in one year, he will pay a lot more tax on the last dollar of income since it will be taxed at a higher marginal rate than if he hadn’t earned as much that year. He really can’t delay his day of reckoning and pay tax on some of the extra money he earned this year until a year when his business is not faring so well. Thus, even if he wanted to reinvest a bunch of the money back into his business, he might only have $.50 on the dollar or less, depending on where he lived, on at least part of his earnings in high income years.

Jill, on the other hand, has far more tax control. In her case, she can decide how much money to pay out of her company to herself in salary, which means she can avoid paying tax personally at high marginal rates by not paying out money she might want to reinvest to either grow her business or to set aside for a rainy day which, as you may know, are not uncommon in Vancouver. In B.C., the first $500,000 of profit, after Jill pays herself a salary and deducts all other expenses, is taxed at about 12% at this point. Accordingly, instead of having only the $.50 after taxes that Joe might have to buy a new business laptop or a new widget-maker, Jill would have perhaps $.88 left to do so. The same principle would apply if they both wanted to buy office space or use the extra money to invest in some crazy investment their neighbour talked about that they’re positive will double within a year.

If Jill’s net profits exceeded $500,000 or she gets caught by a provision in the new tax rules for investment income inside CCPCs just announced in March’s budget that can reduce how much of her active business income can be taxed at 12%, the excess will be taxed at around 27% out Vancouver way. Thus, even though she won’t have as much money left to reinvest on the excess portion than the money that was taxed at 12% (i.e. $.73 vs. $.88 per dollar), she’ll still have a lot more cash for widget-buying than Joe who might have only $.50 or even less if living in places like Toronto on money that was taxed at really high personal rates.

On the other hand, when Jill wants to take the same $.88 or $73 left over after her company paid tax on it out of the company, she will have to pay some tax personally on that money in order for her to be left in a similar position as Joe, who has probably already paid a lot more tax on the money. It could be Jill takes the money out in the same year that it was earned or perhaps a decade later. For now, let’s just assume that this happened during the same year as her company (“Jillco”) earned the profits in the first place. In this instance, perhaps Jill decided to pay herself through dividends instead of salary because she didn’t want to pay any more into the CPP and was willing to forgo earning any more RRSP room and some of the other perks that can come from taking salary instead of dividends.

In any event, whatever the reason behind Jill’s decision, this is where integration theory comes into play once again. It wants Jill and Joe to pay about the same amount of tax on their personal earnings that year. Since Jill will be earning dividends paid from money that was already taxed in Jillco, it’s only fair that she gets credit for either the 12% or 27% that the company already paid on these business earnings.

Salary vs. Dividend Comparison – Integration Theory in Action

This example shows the different tax results if Jill was already earning $100,000 and needed to decide what to do if her company made an extra $1,000 in profits. The size of any dividend cheque will depend on whether the income was first taxed corporately at the 12% or 27% rate, as this tax bill needs to be deducted from the $1,000 profit before paying out dividends. If taxed at the lower rate, the $880 dividend ($1,000 minus $120 in tax) paid out will be taxed as a small business dividend, while if taxed at the general rate, the $730 dividend ($1,000 minus $270 in tax) will be an eligible dividend.  When they talk about “eligible dividends”, they just mean a dividend that is eligible for more tax relief in the recipient’s hands. In this case, the higher tax credit generated on eligible dividends is intended to compensate Jill for having to pay tax at a higher rate on the money corporately than if she had been able to pay tax on it at the 12% rate.

To further make the numbers jibe, the actual amount of Jill’s dividend payments will be increased (“grossed-up”) by 16% (i.e. increased from $880 to $1020.80 in taxable income) if a small business dividend and by 38% (i.e. increased from $730 to $1007.40 in taxable income) for an eligible dividend for income tax purposes. The purpose behind this additional mathematical madness is to make sure that Jill is paying tax on the same $1,000 (give or take) and in the same tax bracket as would have been the case if she’d taken the money as salary. As you’ll see below, after the gross up, Jill will be declaring about $1,000 worth of income any way you slice it. On the other hand, she will get a dividend tax credit of 25.0198% of the grossed-up amount of $1,007.40 if she receives an eligible dividend  (which is 34.53% of $730 she actually received) received in order to compensate her for the 27% tax Jillco had already paid on that same $1,000.If she gets an ineligible / small business dividend instead, she’ll get a dividend tax credit of 12.1013 of the grossed-up amount of $1,007.40 (14.0348% of the $880 she actual receives).

Crunching the Numbers

If Jill takes the extra $1,000 as salary or if Joe had been the one earning the extra $1,000 as a sole proprietor after already making $100,000 that year:

• $1,000 – 38.29% (the marginal tax rate for someone earning $100,000 in income).
• After-tax amount in Jill or Joe’s jeans: $617.10

In other words, if Jill takes the extra $1,000 in salary rather than as dividends, she’d be left with exactly the same amount as Joe. It’s only when the money gets paid out as dividends that things start to change.

If Jill first paid 12% small business tax in Jillco and took the remaining amount as small business dividend:

• Amount paid out as dividend ($1,000 net of 12% small business tax): $880. (“A”)
• Grossed-up Dividend: $1,020.80 (A ($880) x 1.16 (i.e. a 16% gross-up) (“B”).
• Tax on Grossed-up Amount: $390.86 (B ($1,020.80) x .3829 marginal tax rate) (“C”)
• Small Business Dividend Tax Credit: $123.53 (B ($1020.80) x .121013) (“D”)
• Total Personal Income Tax Owing (C-D or $390.86 – $123.53): $267.33 (“E”)
• After-tax money in Jill’s jeans (A-E) or $880 – $267.33: $612.67

If Jill first paid 27% on the $1,000 in Jillco and received the remaining amount as an eligible dividend:

• Amount paid out as dividend ($1,000 net of 27% small business rate tax): $730. (“A”)
• Grossed-up Dividend: $1,007.40 (A or $730 x 1.38) (“B”).
• Tax on Grossed-up Amount: $385.73 (B or $1,007.40  x .3829 marginal tax rate) (“C”)
• Small Business Dividend Tax Credit: $252.05 (B or $1,007.40 x .250198) (“D”)
• Total Personal Income Tax Owing (C-D) or $385.73 -$252.05: $133.68 (“E”)
• After-tax amount in Jill’s jeans (A-E) $730 -$133.68: $596.32

In summary, although it’s not perfect integration, the size of the wad in the back of Jill’s jeans is pretty similar in all three scenarios after the dust settles. Eligible dividends are more valuable to recipients because they produce a bigger tax credit.  Fortunately, you won’t have to do all of my calculations going forward, as there are tax charts that cut to the chase and tell your net tax rate after applying the dividend tax credit when receiving any type of dividends at any income level. Unfortunately, you should still calculate the grossed-up amount of any dividends you wish to pay out in advance to ensure that you don’t mistakenly push yourself into a higher tax bracket than intended. In the end, tax planning involves trying to pay the right amount of dividends to the right person during the right tax year so that they don’t receive too much total income from their particular mix of company salary, eligible and small business dividends, as well as other income they earn personally from other sources like pensions, personally-held investments and so on. This requires both knowing how dividends are taxed and at what income levels the different tax rates kick in. Hopefully, this article and a link to current tax rates in your province of residence will steer you in the right direction: https://www.taxtips.ca/marginaltaxrates.htm

Capital Dividends

 Before wrapping up today’s missive, we need to talk about one final type of dividend that Jill might receive from Jillco from time to time. If Jillco realizes capital gains, such as from selling an office building or from the stock that crazy neighbour talked her into buying several paragraphs ago, integration theory needs to account for the 50% that Joe would have received tax-free in his own hands if he was the one selling the building or stock. Likewise, if Joe owned life insurance on his key employee, Dick (of Dick and Jane fame), he’s receive the entire death benefit in his own hands tax-free.

I’ll have a lot more to say about capital dividends going forward, when I talk about how passive or investment income is taxed inside Jillco. For now, the key is that our tax system is designed so that Jillco can pay out the non-taxable 50% of any capital gains it earns and a portion (although not necessarily all) of any life insurance death benefit it receives to Jill. Jillco receives both the 50% non-taxable portion of any capital gain and 100% of the death benefit of a qualifying life insurance policy tax-free, just as Joe does. The problem was that both eligible and small business dividends would require Jill to pay tax on any amount received, which would put her in a worse position than Jack, who gets that money for his own use tax-free.

To solve this problem, the government created “capital dividends”, which Jill can receive from Jillco tax-free. Jillco’s accountant is in charge of tracking the non-taxable portion of any capital gain, minus any capital losses Jillco earns that year, such as if Jillco sold the stock Jill had heard about from her crazy neighbour at a loss. Jillco would also get credit for the death benefit of any life insurance policies it received minus a tax adjustment. In simple terms, most or all of any term life insurance policy could be paid out to Jill for free through capital dividends, but for permanent policies with a cash or investment portion, some of that value would still go to Jillco tax-free but would have to be paid out to Jill as taxable small business dividends, which all depends on the type of policy, the size of the investment portion and the age of the deceased at the time of his passing (the older the deceased, the greater the percentage of death benefit that can be paid to Jill for free). Fortunately, insurance companies track these tax values, which will change from year to year. To this total, her accountant would also add any capital dividend room on hand that hadn’t been paid out to Jill in previous years.

In any event, that’s probably more than enough for today. For now, let’s just focus on the fact that sometimes Jill can receive tax-free capital dividends from Jillco when it sells assets that produce capital gains or someone covered by a company life insurance policy dies. We’ll have more to say how the taxable portion of any capital gains (i.e. the 50% that is taxed, as opposed to the 50% paid out as capital dividends) are taxed next time.

Conclusion

If you’ve made it this far, you will hopefully have a better idea of how active business income is taxed and how the different types of dividends fit into the system. You probably have also already heard far too much about integration theory as well. Although today’s article focused on active business income and Jill’s tax situation if she paid out all her corporate earnings as soon as possible, many businessowners benefit the most when they stockpile excess earnings within their company so they have more to invest for the future and in the expectation that they might be able to pay less tax on the money in the future when they withdraw it as dividends if they are then in a lower tax bracket. Accordingly, my next article will attempt to start deciphering the mystery of how investment income is taxed in CCPCs, since investing corporately rather than personally is one of the main benefits of incorporating your business. Today’s article is hopefully a useful first step along that convoluted road. Just don’t be surprised if integration theory once more makes a surprise appearance.

Investing Inside an Insurance Policy –Part 3: Universal Life Insurance as an Investment

Introduction

Think that life insurance is just a tool to make sure that junior gets the university vacation if you die in your 40s, your spouse doesn’t have to worry about mortgage payments if you die in your 60’s or your kids have enough money to pay the final tax bill on the family cottage if you die in your 80’s?  Not so fast, says the insurance industry. They are now seeking a place at the table when clients discuss ways of funding their own retirement, particularly for those clients in higher tax brackets and those that have their own corporations.

The first two parts of this series have detailed some of the significant tax advantages enjoyed by life insurance and steps you can take to mitigate risk when looking to invest through life insurance or if you’re already the proud owner of a policy to call your own. To date, I’ve said little about your actual investment options inside an insurance policy, although I’ll focus solely on “Universal Life” or UL Policies, the insurance that most closely resemble traditional investments. For those of who are fans of Participating Whole Life (“Par”) Policies, you’ll unfortunately have to wait until next time. Finally, regardless of whether you’re looking at either of these types of policies or even more basic permanent policies, my (hopefully) final article in this series will hopefully provide you with guidelines to use when measuring life insurance against traditional investments, as any comparison between options is only as accurate as the underlying assumptions.

But, before I go any further, I wish to thank the insurance advisors I’ve canvassed for their insurance investment recommendations: Lee Brooks of View 360 Insurance Advisory (New Westminster, British Columbia), Tyler Eastman, Sun Life Advisor (Terrace, British Columbia), John Ong, Certified Financial Planner (Vancouver, British Columbia) and fellow Money Saver Contributing Editor, Rino Rancanelli, owner of CorporateTaxShelter.ca(Oakville, Ontario).

Setting the Stage

While Par Policies are something of a mysterious black box that spits out policy dividends each year and often offer guaranteed increases in cash value, UL policies are generally more transparent, flexible and multi-purpose creatures. There is a set minimum premium payable monthly or yearly for guaranteed death benefit or “face value” of the policy but extra contributions are allowed into what is called an “accumulating fund” that is essentially a tax-free investment account whose balance at death is paid out tax-free on top of the face value. Each insurer offers its own set of different investment options. Traditionally, this meant predominantly mutual funds, which has often meant more uncertain and volatile returns than Par Policies and some rather steep investment management fees.

Like Par Policies, the greatest risk to owning a UL is having the policy run out of money when the owner doesn’t have extra funds to contribute to the cause. Traditionally, there has been a far greater chance of this happening for UL policies than their Par compatriots for a few reasons:

• Although a UL policy will offer you far more upside than a Par Policy, it also exposes you to double digit losses in a year if you pick riskier investment options and all does not go well.
• Inability to lock in gains. If you get paid a policy dividend in your Par policy, it gets added to the cash value and the insurance company can’t take it away from you the next year if their investments don’t perform as expected.Accordingly, they invest more conservatively and factor lots of margin for safety when setting premium rates. UL policies give clients the chance for making a lot more profit but don’t generally provide them with this safety net, except for “limited pay” policies that at least ensure that you are no longer responsible for ongoing premium payments after a set period of time even though any additional contributions you’ve invested are still fully at risk. I have listed a few exceptions to the rule later in this article.
• Overly optimistic investment return assumptions. In the 80’s and 90’s, when markets soaring and interest rates were high, UL policies were the policies of choice, while Par Policies were considered yesterday’s news. Although illustrations for both types of policies purchased during this period have not lived up to expectations, UL policies (particularly if invested in mostly equities) took far more of the pain. While Par policies ended up paying less than everyone hoped, at least they continued to pay out policy dividends year over year. In contrast, negative portfolio returns in UL policies meant that the anticipated growth that was supposed to pay future policy premiums was not merely growing slower than expected but was actually shrinking. That meant policies running out of money far sooner.
• Yearly Increases in Premiums. It was common for clients to purchase UL policies that had yearly increases in their insurance costs (sometimes to set ages and sometimes indefinitely) to keep costs low in the early years so they could have more money working for them in their investment fund. The theory was that the opportunity to have more money in the market longer helped clients since the extra profits they would earn on their investments in the early years would pay for the increased insurance costs on the back end. When performance lagged and the clients didn’t continue to contribute fresh funds to keep their UL policies on course, the increases in fees, modest for younger clients but growing significantly for older clients, ultimately made many policies unsustainable. By contrast, Par Policies generally offer a level premium for life so that, even if they weren’t able to be self-funding as early as originally illustrated, the cost of keeping the policy going was not nearly as significant.

On the other hand, life is about learning from one’s mistakes. Just because UL policies have performed badly in the past, doesn’t mean that there is no place for them in your future. The potential tax savings and advantages offered by these policies are real and can still offer significant benefits to the right clients. For the same reason that it can be a mistake for investors to completely shun investing in the stock market just because they’ve been bitten in the past, it may also be a missed opportunity for investors to not investigate using ULs now merely because of past problems. The secret is often to learn from and fix the mistakes of the past rather than abandoning a strategy without a backward glance.

Along those lines, the insurance industry has made some significant changes to their investment offerings and the investment fees charged on these offerings that do a lot to mitigate risk and enhance performance. Moreover, no one is purchasing these policies on the expectation of continuous double-digit returns, which means that it is now a lot easier for ULs to live up to their promises. In defence of insurance advisors past, however, it wasn’t merely the insurance industry that was assuming that investors in that period would continue to enjoy double-digit returns in perpetuity; many investment portfolios burdened by similar unrealistic expectations also floundered and flopped.

Finally, more clients select policies with level premiums, specially designed policies that allow tax sheltering but reduce or even almost eliminate the insurance costs over time, or, if they do choose yearly increases in costs, doing so with a contractual right to switch over to a fixed yearly charge at a later date of their choosing at a predetermined rate. In other words, they can take advantage of the rather significant savings and potentially improved overall results by paying yearly increasing rates for a number of years but preselecting a time to bite the bullet and switch over to level rates based on their age at that time in order to control future costs. In the end, UL policies are a lot like an electric drill– if used in the right situation, in a careful, safe manner and regularly maintained, it just might be the best tool for the right job, although if used inappropriate, there is the chance of pain and shocks.

Changes in UL Investment Options

In my previous article in these series, I argued that it’s important to manage your UL policy in the same way as the rest of your investments. This means reviewing and potentially rebalancing the investments inside your portfolio at least once a year, changing your holdings if your time horizon and risk tolerance change and getting your insurance advisor to update your policy illustrations every few years so you can make small changes immediately rather than facing large changes later.

Noting all of this, in the end, it still often comes down to investments inside the policy. My personal bias is to use UL policies for the slow and steady portion of your portfolio rather than the “shoot for the moon” component. The less volatile your investments, the less likely things can go wrong. Furthermore, for the same reasons I love investments that pay interest and dividends along the way in order to reduce the need to eat into capital during down markets, I love similar investments inside UL policies in order to generate cash to pay the annual premium costs.

Fortunately, there are an ever-increasing number of investment options. One insurer actually offers more than 200 investment choices for UL investors, although I am not completely convinced that more is always better. Many of these are mutual funds, often the same ones you could select within an RRSP or an open account, but they aren’t the only game in town. Here are a few of the more innovative choices:

• A Mortgage Investment Corporation. BMO offers you the chance to invest in a portfolio of mortgages held by a Mortgage Investment Corporation (“MIC”) that would pay around 6% and is a non-stock market investment. Since this is a private investment, this means not having to worry about stock market fluctuations and, despite a low interest rate environment, earning a yield that is probably higher than the one used to illustrate the performance of your UL Policy. It also means that yield should increase relatively quickly when mortgage rates go up, as the mortgages are all two years or less and there are always mortgages coming due and fresh money is being lent at the new market rate.
• A Stock Market Investment that Guarantees No Losses. BMO offers the “Guaranteed Market Index Account”, which it describes as offering the security of a GIC with exposure to the TSX 60. It’s a simple proposition – you get 50% of the market upside each year but none of the downside. Although this doesn’t eliminate volatility and still means having to eat into capital during a bad year to pay premiums, it does offer some exposure to the market during good times and better protects your capital during the bad ones.
• Absolute Return Funds. Sun Life offers a fund designed to make a yearly profit of 5% more than the overnight lending rate over every 3-year period, regardless of market conditions by using a bunch of strategies, depending on market conditions at that time. Thus, instead of claiming a successful record merely because it has lost less than its competitors, it is only successful if it’s making you the promised profit, regardless of what the market does. Furthermore, they strive to be less than half as volatile as the global stock market.
• Diversified Accounts. Sun Life Offers the Sun Life Diversified Account that reminds me a lot of the investment portfolio you’d receive inside a Par Policy: private mortgages, some private investments, real estate, public bonds and some public equities. It also smooths returns in order to provide less volatility and predictability. At the time of this article, it pays daily interest equal to about 4% per year and guarantees that your yearly return will never drop below 0%.
• Hybrid UL / Par Policies. Industrial Alliance offers a product called the “Equibuild” that is designed to give you the best of both worlds. The basic premiums go into a fund that generates guaranteed cash value like you’d enjoy with a Par Policy and pays policy dividends. Any extra money you contribute can be allocated to Equibuild Fund, which is the Par policy equivalent, or towards more traditional UL investments. There is also even the option to use extra money to buy an additional paid up death benefit each year. As another feature, there is a cash for life feature where the owner is guaranteed payment for life if he wants to use the policy for retirement purposes.

Obviously, there are likely other intriguing insurance investment options out there, as these are only some of the options I’ve discovered on my own and through my cadre of insurance advisor friends.  I suggest doing what I do when working with financial planning clients who are potentially interested in life insurance – collaborating with a licensed insurance advisor (which I am not, as my focus is on big picture planning despite owning my Certified Life Underwriter Designation and having spent 15 years advising insurance advisors) who can make specific policy recommendations.

Unless your insurance advisor is experienced in overall financial planning and knows your situation, I strongly suggest getting a financial planner familiar with your overarching financial plan review the size, type and ownership of the policy suggested to ensure that it’s the best possible fit. Think about buying life insurance like shoe shopping – even though you need new runners for an upcoming marathon, if you buy the wrong pair or overpay, you may either not make it across the finish line or, if you do, the resulting discomfort and stress of cramped toes or living outside your budget may ultimately make the experience a lot less enjoyable.

Also, when deciding whether to own the policy personally, corporately, in a trust or as a combination of these choices, it’s important to get it right the first time, as there are often tax costs that can arise if you have to change ownership of a policy later. Unfortunately, I often get involved after the policy is already in place, when options are more limited and changes can be expensive.

Conclusion

Although many clients feel more comfortable with Par Policies (which I will talk about more next time), I still see UL Policies as a strong choice for the right client in the right situation. They offer more flexibility and transparency. For example, some UL policies both allow the entire cash value of the investment account to be withdrawn tax-free during life in the event of a disability and allow you to change your policy investments at your own discretion, which may allow clients to perform better over the long term if they play their cards right.

In the end, each policy has its own advantages – for example, clients planning on borrowing against their policies during retirement are often able to borrow more against the cash value of Par Policies than their UL cousins while someone planning on withdrawing directly from their policy during retirement might be better served with a cheaper UL policy with reducing insurance costs. Ultimately, I believe that insurance can become a valuable tool in many retirement plans and that the type of policy best suited to the purpose depends on the client and situation. In these days of steadily increasing income tax rates, life insurance and all the tax benefits that come with it might be worth a second look when looking to fund your retirement.

Leave to Grow or Withdraw Some Dough: Factors to Consider When Pondering Early RRSP Withdrawals – Part 2

In my first article in this series, I hopefully persuaded at least some of you that sometimes, getting your money out of your RRSP or RRIF before absolutely necessary can be a better than average financial decision. I showed you a specific calculation where calling for your cash early and investing it tax efficiently outside of your RRSP resulted in a significantly larger cheque for your heirs at death, as well as increased financial flexibility for you along the way. On the other hand, I hedged my bets and suggested that whether or not you should do the same as our fictitious hero depended a lot depended on the specifics of your own financial situation, vaguely promising to provide more details later.

In today’s offering, I will do just that in excruciating detail. There really are a surprisingly large number of factors to consider when deciding what to do with your RRSP and it is generally impossible to combine them all into a single neat algorithm or formula of universal application. Read on and see for yourself. But when you are done reading both this article and the final installment in this series, I am still hopeful that you have enough general principals and factors to consider so you can make an educated decision on what is right for you. Time to begin. For ease of reference, I will resort to bullet points. 

• Do you have a really, really large RRSP that you doubt you’ll fully spend during your lifetime? If so, this will mean that a lot of it will ultimately be taxed at the highest marginal tax rate, which can mean losing over 50% of the remaining balance at that time to our provincial and federal governments, depending on your province of residence. As an aside, I see the Federal Liberal Government’s decision to create a new tax the other year that ultimately increased the top tax rate by 4% in order to purportedly “tax the rich” as a hidden estate tax that will affect the majority of Canadians.  This is because most of us will be taxed at this top rate at our death or the deaths of our spouses when, or those of us destined to inherit will have inheritances reduced as a result of these rates when our parents or other relatives pass on. The higher the highest tax rate grows, the more incentive there is to reduce the amount of RRSPs and RRIFs that might be taxed at this rate on your death, particularly if in a significantly lower tax bracket right now.

• Will You Be Able to Tax-Efficiently Deploy the Money You Withdraw? Although you’ll have fewer dollars to work with than if you leave your RRSP well enough alone, you can potentially make up all or some of difference if the money you withdraw grows more tax-efficiently than inside your RRSP or RRIF. In the example in my last article, our hero was in a low enough tax bracket that non-registered dividends were almost free money for him, which offset the fact that he is earning fewer dividends per year in the non-registered portfolio he created with the after-tax value of his early RRSP withdrawals than inside his RRSP.  Although the portfolio from his RRSP withdrawal cash will appear to grow slower than if left in his RRSP, the real question is how much is each worth after taxes rather than before his day of reckoning. As the example showed, a small but efficient non-registered portfolio may actually provide more value in the long run.

Eligible dividends from Canadian companies can be extremely tax efficient for Canadians in the first few tax brackets. Other tax efficient ways of using your RRSP withdrawals are:

• funding your TFSAs or potentially those of other family members;
• investing in products that pay return of capital or that focus on capital appreciation rather than on paying income;
• buying life insurance or other insurances, such as LongTerm Care Insurance;
• paying down debt;
• gifting to children in lower tax brackets to invest or to buy that first home;
• putting it in a trust for the benefit of future family members so gains and growth can be taxed in some of their hands

Adding a wrinkle to the debt repayment strategy, if you do have debt but still like the thought of investing, consider using the RRSP money to pay off non-deductible debt but then borrow the money back for investment purposes. The debt is now an investment loan and the interest is tax-deductible if you invest in an open account (i.e. not in your TFSA). Thus, if you invest to earn Canadian dividends and are in a relatively low tax bracket, the low tax rate (or potential tax refund) they generate, coupled with extra taxes you save by writing off your borrowing costs against other income may be a game changer.

Also, if you have a lot of unused capital losses on the books, you may ultimately be able to apply them against some of the future gains in your non-registered portfolio along the way, which you might not otherwise be able to use until death. This ultimately means that you could get a lot of capital gains for free along the way.

• What are the Relative Rates of Return if You Leave the Money in Your RRSP Compared to What You Do When You Withdraw It?Until now, I’ve mostly assumed that you’d use the money you take from your RRSP to buy back the same investment in your non-registered portfolio or TFSA.  That is not always the case. Perhaps you use it to pay off high interest loans for you a family member. In that case, you may be getting a better return on the money than if left alone in your RRSP, even when ignoring the future tax bill on your RRSP growth. Likewise, you might hope to get a better return from buying a rental property or, indirectly, by helping a child buy their first home, then by keeping it inside your RRSP.

• How Tax-Efficiently Can You Withdraw Your RRSP Money Now? As I’ve written about in previous articles, if you can get your RRSP money out for free at any point in time, such as if you’re not earning any money, then it’s probably a good idea, especially if you have TFSA room. The less tax you pay on withdrawal, the less hard your non-registered portfolio needs to work to replace the lost profits you would have earned on the tax you’re paying ahead of schedule, particularly if you plan on deploying the money you withdraw tax- efficiently. Thus, it often makes sense to systematically withdraw RRSP money over a number of years at lower rates rather than melting it down all at once and paying more total taxes even if means having to wait a little longer.

If you are over 65, you can also have up to 50% of your withdrawals taxed in your spouse’s hands at their rate if you put some of your RRSP into a RRIF and make the withdrawal from the RRIF rather than your RRSP.Thus, you can potentially access more money at a lower combined rate if the tax load is shared by two.

Finally, there are other more advanced techniques for getting money out on the cheap, such as buying flow through shares in order to create a tax-deduction or taking out an investment loan. That last idea involves borrowing money to buy tax-efficient investments that produce income. Since you are able to write off the interest on that loan and the tax deduction is higher than the bill from the investment income, you can thus pull out money from your RRSP equal to the extra write-off you get on your interest net of any taxes you pay on the income you generate from the borrowed money. In other words, the tax bill from withdrawing the money from your RRSP is offset by the tax deduction you get on your investment loan. This is obviously not a strategy for many of us and, if you are looking at this, I strongly suggest investing the borrowed money conservatively and to even consider looking at segregated funds that protect you against losses on your death, although the fees for these products are not insignificant.

• What Tax Rate Do You Expect to Pay on the RRSP Money Later if You Leave It Alone for Now? Obviously, the higher the rate you expect to pay later, the greater the incentive for pulling it out now. As I said earlier, if any remains at your death, many of us will have to pay tax on it at the highest rate at that time (which could actually be higher than it is right now, unless you believe taxes will go down rather than up in the future, which currently seems synonymous with a belief in a jolly fellow named St. Nick and that there is a fairy that pays money for teeth). For the money, you plan on accessing during your lifetime, here are some of the things to consider when anticipating the future tax costs if you leave your RRSP money alone for as long as possible.

To begin, you will eventually need to start withdrawing the money at age 72 and must withdraw a minimum amount each year from either than age or from the year after you first convert your RRSP to a RRIF.Although you can control how much money you withdraw from your RRSP and RRIF prior to age 72 by only RRIFing a portion of your RRSP equal to what you want to withdraw each year, you are at the mercy of the government rules after that point. In a nutshell, once you RRIF, you must withdraw a set percentage of your RRIF value each year based on what your RRIF is worth each January 1^st. This rate increases each year depending on your age or, if you set this up when you open your RRIF, your spouse’s age. Obviously, it is usually a really good idea to pick the younger spouse’s age, as this means having to withdraw less money each year, particularly since this doesn’t prevent you from withdrawing more than the minimum if necessary.

For someone who is 72 before January 1, this means having to withdraw 5.4% of what was previously your RRSP that year. This percentage increases yearly. Here is a link to a table from one of my favourite websites that tells you the required withdrawal rates for different ages: http://www.taxtips.ca/rrsp/rrif-minimum-withdrawal-factors.htm. The upshot of this is that, whether you like it or not, you’re forced to pull out $54,000 per million in RRIF dollars and climbing per year from that point. Returning to last article’s example, if our hero left his RRSPs alone and they were worth about $2,000,000 by that point, he’d be forced to withdraw about $108,000 per year and be taxed on it accordingly after also including any income he earns from other sources like pensions, rental properties, non-registered investments, and private companies. Although he wouldn’t be at the highest tax rate, he would be paying a lot more tax per dollar than if he had withdrawn some of it in his 60’s.

Our friend would also lose all of his OAS pension to the OAS clawback, which I see as a hidden tax. Although he would have paid tax on his pension anyway, I would estimate that each dollar of OAS pension lost is like increasing his tax rate by, conservatively, 8%. Reaching higher tax brackets also turns eligible dividends from a best friend to something of a frenemy. Although they are still more tax efficient than interest, capital gains are now preferable in many ways. Instead of paying perhaps 8% on average in tax on dividends, he will now be paying 25% tax for dividends taxed in that tax bracket, although this can climb to as high as almost 40% in Ontario if his income topped about $220,000! Also, our tax system shows each dividend dollar as $1.38 of income for tax purposes, which pushes payers into higher tax rates sooner, which can also make it easier to trigger a clawback of OAS pension or increase its impact.

One strategy I encourage exploring if you are hale and hearty is deferring when you start your OAS and CPP pensions until as late as age 70 in order to reduce your income until that time and potentially withdraw more of your RRSP income on the cheap before then. Not only do get paid by the government to defer these pensions (i.e. they will pay you a higher pension per year when you do start getting pension cheques); taxpayers in potentially higher tax brackets have a better chance of keeping more of their OAS pensions when they do finally arrive, as their total income has to be significantly higher at that point before all of their OAS Pension is gone to the clawback but not forgotten.

If our fictional hero was married, he would be able to hopefully allocate some of his RRIF income to his spouse and reduce the tax hit, although that depends on how much money she is earning on her own and her age. If she was younger and they set up his RRIF based on her age, then they wouldn’t have to withdraw as much money per year. Also, she won’t have to withdraw any of her own RRSP money until she turns 72, which makes it easier to keep her in a lower tax bracket until then. Unfortunately, they could both be in the same boat when she also comes of age and their family tax bill will increase accordingly.

Although the RRIF withdrawal rate increases each year, it’s important to remember that the value of the RRIF will probably start to shrink over time unless our imaginary friend corners the market and consistently earns more he has to withdraw each year. Thus, it is quite possible that his total RRIF withdrawals will shrink at some point and potentially drop him into a lower tax bracket, although if he’s merely reinvesting the money has withdrawn along the way, his tax bill on his non-registered portfolio might offset some of these potential savings once his RRIF withdrawals start to decrease.

Finally, what if our protagonist’s wife also had a substantial RRIF, work pension or income from other sources? Many Canadian couples do a great job of protecting their OAS pensions and reducing their combined tax bill by arranging their affairs so both of them are in a similar tax bracket during retirements. When one of them passes, however, the survivor is often pushed into a higher tax bracket and potentially the OAS clawback zone. For example, if both spouses were earning $65,000 or $130,000 before taxes, combined, both spouses would get their full OAS pensions and would be a tax bracket of around 30% in most province. After the first spouse’s death, the survivor will lose her spouse’s OAS pension and at least part of his CPP pension (and perhaps all or some of any work pensions).Thus, although there will be less money coming in when they were both alive, she will now lose all of her OAS pension and will have some of the combined RRIF money taxed at over 43% in Ontario and about 41% in B.C. Accordingly, the benefits of her spouse cashing in some of his RRSP early and reducing the amount to be withdrawn at higher rates during his spouse’s widowhood can have a big impact down the road even if not particularly helpful early on.

• Flexibility. As outlined earlier in a different context, there is a lot more you can do with non-registered money than with money inside your RRSP, such as gifting to children to help them buy homes, paying down your own debt, buying rental properties and putting it into a trust, where income and gains can be paid and reported on other family members’ tax returns if done correctly. Just as importantly, it is far easier to access and triggers far less tax than if you need to pull money out of your RRSP or RRIF for an emergency during a time you are already in a high tax bracket. For example, someone looking to pay for a private retirement facility can easily have expenses exceeding $7,000 per month. If this has to be funded by increasing RRIF withdrawals by enough to both eliminate the shortfall and cover the taxes owing on the extra withdrawals, this could be a rather expensive decision. It could also be the difference between keeping most or all of an OAS pension or making a one-way trip to clawback city.

Conclusion

Despite the preceding pages, there are still many more factors to take into account when deciding what to do with your RRSPs and RRIFs. In my next article, I promise to finish up this grocery list of relevant considerations so you can get on to the important business of better evaluating your own situation.

Withdrawing From Your RRSP’s

Besides general questions regarding the meaning of life, whether the Blue Jays have a chance of making the playoffs in 2018 and how to avoid OAS pension clawback, many of my clients most like to talk about the best way of withdrawing money from their RRSPs. The answer is, it depends.  Although this sounds exactly like the sort of non-answer you’d expect from a man with a law degree, this time it is actually the truth. Rather than switching the conversation back to the benefits of meditation or whether Devon Travis will return to man second base next year for the boys in blue, I will explain what I mean and what factors to consider when deciding how to minimize taxes on your RRSP nest egg.  Although your picture may still be a little murky by the time I’m done, I’m hopeful that reading this article and those to follow over the ensuring months will provide you with enough to ultimately guide you towards the answers you seek.

By way of preamble, I have been writing this article in my mind for over a year, ever since getting an email from one reader who’d read one of my RRSP planning articles last year in his local library. He disagreed with a few of my assertions and also generally argued that clients are always better off leaving money in their RRSPs as long as possible. Fortunately, for my clients’ sake and my own self respect as a planner, after reviewing his comments and my article, I was able to quickly find the flaws in his various arguments, reaffirm my own conclusions and then respond to him before returning to my thoughts to OAS pensions and Blue Jays’ baseball. I also planned to write an article showing why it isn’t always such a good idea to keep money growing in your RRSP as long as possible after reviewing his elaborate mathematic calculations that were unfortunately flawed and incomplete.

That day has now finally come. Today’s article focuses on explaining why leaving money in your RRSP as long as humanly possible might be an expensive mistake for some of us, although not always. As the old cliché says, the devil is in the details. There will be other articles in this series to follow that will provide the factors to consider when reviewing your own situation in order to apply these general principals to your own specific situation, but my mission today is to merely set the stage for what is to follow.

Overview

Although tax planners generally love taxation procrastination (i.e. delaying triggering tax bills as long as possible), there are exceptions to this rule. First, it you are in a significantly lower tax bracket now than you expect to be in the future, then it might make sense to take your lumps now if it means avoiding greater pain later.

People who withdraw money from an RRSP ahead of schedule are willing to accept a smaller, nimbler, tax-efficient portfolio in the expectation that it is really worth more to them or their heirs than a larger RRSP or RRIF portfolio that might after taxes, particularly if forced to pay 53.53% in Ontario or 47.7% British Columbia on that money at death if in the highest tax bracket.

When determining whether early withdrawals make sense, you have to accept that you are missing out on the growth on the portion of your RRSP investments you are now paying in taxes that would have otherwise stayed invested and be confident that, although you will now have less total dollars working for you, that the benefits of minimizing the tax hit by triggering a bill earlier than necessary will compensate you for the lost pre-tax compound growth you would have received by putting off your day of reckoning. In other words, you need to be willing to work with a smaller investment portfolio than would have been the case if you’d left things well enough alone in the hopes that it will be worth after tax than if you’d kept your RRSP intact.

On a related note, you need to compare how the portfolio you create when you withdraw money ahead of schedule from your RRSP and reinvest it grows will be taxed going forward compared to your RRSPs. As Canadians know or will find out the hard way, everything inside your RRSPs will be fully taxed upon withdrawal. On the other hand, if the extra money withdrawn from your RRSP is invested in your TFSA or in a non-registered account that pays eligible dividends from Canadian companies or is geared towards capital gains, then your new portfolio will have far less tax drag per dollar than your RRSP. If you invest for capital gains, you will only pay tax on 50% of the growth, compared to 100% if you owned the same investment inside an RRSP.

Continuing with the topic of taxation, eligible dividends can be even more tax efficient for many Canadians when owned in an open account. In Ontario, if your income is below approximately $46,000, you not only don’t pay tax on these dividends; in fact, you actually get money back from the government instead! Moreover, if your income is between about $46,000 and $74,000, then the top tax rate on dividends “soars” to only 6.39%. In comparison, if those dividends were paid inside your RRSP, they will eventually be taxed at 29.65% if withdrawn when in that tax bracket. In other words, if paid inside your RRSP, you could easily be paying more than 4 times as much tax per dividend dollar than if you received the dividend in your non-registered account upon withdrawal. If that money stay put until death, however, that’s when things get really unpleasant. If you are in the top tax bracket at that time, as is not uncommon, that same dividend dollar would be taxed at 53.53%, which means paying more than 8 times more tax than if you’d earned that dividend early in your open account!

Early RRSP Withdrawals – an Example

Here is a very basic example with very approximate numbers. I will use Ontario tax rates. Consider an Ontario investor around 60 years of age with $1,000,000 in his RRSP and about $46,000 in other income, which is enough to satisfy his needs, so that any additional withdrawals can be reinvested in his non-registered account for the future. He earns 6.5% per year on his RRSP investments, 3.75% each in capital gains and eligible dividends and, like many Money Saver investors, plans to buy and hold. He is debating between pulling out $40,000 per year for the next 12 years before he officially must convert his RRSP to a RRIF and commence making withdrawals or, alternatively, leaving things well enough alone until he is forced to start withdrawing RRIF funds.

Assuming he pays 30% tax on the early withdrawals, he would have $28,000 per year left to reinvest if he makes his withdrawals each January 1^st,. Focusing first on the 3.75% yearly capital growth he would earn on his yearly $28,000 non-registered contributions, this amounts to$414,739after 12 years, of which $78,739 is unrealized capital gains. This ignores any of the dividends this portfolio generates.

Turning to these dividends payments, each year’s withdrawal would pay dividends at 3.75% going forward (which I show as 3.45% after 8% in taxes) which I assume will be reinvested at no cost, such as through a DRIP, so that each year’s dividend stream increases.

In order to crunch the total value of the dividends and their growth, this required calculating 12 separate income streams, as the first year’s dividends will have another 11 years to grow, while the last won’t grow at all using my calculations. There will also be 3.75% capital growth if these dividends are reinvested. Anyway, for the purposes of this calculation, I will assume that the dividends are worth an additional $85,755 after about 12 years with $10,407 in unrealized capital gains. In other words, after including the $414,739 in capital growth on the non-dividend portion, our client has a total non-registered portfolio worth $500,494. If he died at that time, and was in the highest tax bracket, this would leave him with or $476, 634 after taxes, since the bulk of the portfolio was already taxed along the way.

In addition to the non-registered portfolio our client has created with the early withdrawals, his RRSP is still alive and well. Despite the series of $40,000 in withdrawals, would still have $1,434,267 left 12 years later, as the amount he withdrew was actually less than his portfolio’s annual growth. If he died at that point and forced to pay tax on that balance at 53.53%, he would be left with only $666,503. Accordingly, when adding this amount to the $476,634 after-tax value of his non-registered portfolio, their combined after-tax value is worth $1,134,137.

On the other hand, if he does nothing and let his RRSP grow unchecked for the next 12 years, it would grow to a value of $2,129,096. At first blush, this may seem to be the way to go, as is almost $200,000 more than the pre-tax value of his non-registered portfolio and his smaller RRSP if he went with the early withdrawal option. The after-tax values tell a different story. When decimated by tax at 53.53% at death, his RRSP is only worth $989,380 after taxes, which is actually $144,741 less for his heirs than if he’d started his withdrawals early.

Of course, this is a very specific example and only shows, that in the right circumstances, that withdrawing coins from your RRSP early can mean more dollars in your (or your heirs) back pockets later. For example, if our intrepid investor wasn’t investing as tax efficiently in his non-registered portfolio, such as if he was earning primarily interest or realizing his capital gains more frequently, the numbers won’t be as attractive and he might have been better off keeping the money in his RRSP and delaying his day of reckoning.

As well, if our investor had lived to a ripe old age, he would have had the chance to get more of his RRSP or RRIF money out at rates lower than the maximum, thus improving his result. In the end, this example is merely to show that sometimes withdrawing money from your RRSP early can be a good thing, rather than suggesting that it is always the way to go.

Conclusion

Now that I’ve hopefully shown that sometimes pulling money from your RRSP ahead of schedule can make a huge difference in the right circumstances, my next few articles will help you identify the factors to consider when looking at your own account statements and deciding whether to let your RRSPs grow or to start tapping into your dough. Until then, I’ll direct my thoughts to whether or not the Blue Jays will keep or trade Josh Donaldson.