Reduce tax on your assets
There’s always someone at the office or at a party who boasts about paying little tax last year, or using a whole slew of tax write-offs. But for most Canadians, the prospect of paying less tax is about as likely as starring with Christopher Plummer in his next blockbuster movie.
Much tax policy is formulated on the perception that certain people receive tax benefits that others do not (certainly true), and that such inequities should be eliminated so that all taxpayers perceive that they’re being treated fairly (quite likely impossible.)
In the face of this complexity, older Canadians face the important tax-planning challenge of maintaining eligibility for as many age-related tax credits, benefits and deductions as possible.
Not all credits are created equal
For the year 2002 each of us may claim a personal basic exemption of $7,634. If you were born in 1937 or earlier, you are entitled to a further “age exemption” of $3,728. But—and it’s a big ‘but’—you get this exemption only if your net income does not exceed $27,938! If your income is higher, the exemption is eliminated at the rate of 15 per cent of thexcess. (As you’ll see below, “net income” can have an altogether different meaning than you might think.)
At the same time, if you are over age 65, you are likely eligible for Old Age Security benefits. The maximum OAS benefit for the year 2002 was $5,232 but whether you’re entitled to keep the benefits that you received will depend on your net income.
The so-called OAS clawback works like this: If your net income last year exceeded $56,968, you lose OAS benefits at the rate of 15 per cent of the excess. For example, even though an Ontario taxpayer might normally pay tax on OAS benefits at a maximum rate of 40.16 per cent (the combined maximum federal and provincial rate in this province), tax rate would now effectively be 100 per cent on the portion of that money that will be clawed back.
Understanding net income is key
The catch for some OAS pensioners lies in CCRA’s definition of net income, which isn’t always based on your actual income. Most of us would think net income is calculated as income minus losses, right? Not always. Losses may be carried back three years and forward seven if they are “ordinary” in nature, that is, the result of business or rental operations; however, they may be carried back three years and forward indefinitely if they are “capital” in nature, that is, resulting from investments. While this is useful in determining your taxable income, it has no effect on net income.
We need only look at how dividends are taxed to understand why the concept of net income is so important for taxpayers. In Canada, dividends received from taxable Canadian corporations are taxed on the basis of 125 per cent (see below for explanation of the dividend gross-up) of the cash received. You are permitted to deduct 16-2/3 per cent of this enhanced figure as a credit against the income taxes otherwise payable for the year. However, the 125 per cent forms part of net income for clawback purposes, to a maximum of the total received.
So, for example, if you have a taxable capital gain of $10,000 in year-one, this gain forms part of your net income. But if you suffer a net capital loss of $10,000 in year-two, this loss does not enter into the equation at all. In other words, for year-one you could be faced with a clawback of OAS benefits or the age credit because of your capital gains, but in year-two, where you have lost the same amount you previously earned, there is no way you can retrieve that clawback.
Next page: Tax reduction strategies for seniors
Tax reduction strategies for seniors
Amid these complexities, there are steps you can take to help reduce the burden of taxation. We’ve listed a few strategies below but caution that any solution should be looked at and evaluated according to your own particular financial situation.
- Transfer dividend income to spouse or common-law partner
Remember, all dividends you receive from taxable Canadian corporations are included in the calculation of your income at an inflated rate of 125 per cent of what you actually receive. In other words, if you receive dividends of $100, you are taxed as if you received $125. It’s easy to see how this can have a profound effect on your net income for clawback purposes, because it artificially inflates dividend income by 25 per cent.
By electing to have all your taxable Canadian dividends transferred to your spouse’s or common-law partner’s return when preparing your own income tax return, you could reduce your taxable income and increase your spouse’s reported income. This election is made by completing the appropriate sections of the tax return.
However, you must take care to ensure that this transfer of taxable dividend-income does not affect your spouse’s credits and deductions. For example, boosting his or her income above the threshold of $27,938 could mean that your 65-plus spouse would no longer qualify for the full age exemption in that year.
- Split investment income
If you have investments that earn more than the prescribed rate of interest, which is set quarterly by the CCRA based on the prime rate set by the Bank of Canada (currently around three per cent), you can lend your spouse the money necessary to purchase these investments from you. Provided that your spouse actually pays you the interest at the rate prescribed when you make the loan by January of the following year, the attribution rules that normally accompany such a transaction would not apply. This interest, of course, would be taxable in your hands and deductible in your spouse’s. In other words, your spouse could use the borrowed money that you would otherwise have used yourself, to invest in a higher-yield investment.
The ultimate effect is to increase your spouse’s income while reducing your own, in order to keep below the $55,309 net income-level which may otherwise result in the government clawing back all or part of your Old Age Security entitlement of $5,232.27.
- Split CPP benefits
The Canada Pension Plan (CPP) contains rules that allow spouses or common-law partners who are living together to assign retirement pensions to each other. (Note that CPP income may not be split with a dependent child.) If you have lived together continuously during the time you made contributions to the CPP, you and your spouse or common-law partner may elect to divide the CPP receipts equally. Again, you should ensure that you don’t jeopardize any other exemptions by doing so. For example, you might not want to increase your spouse’s income beyond $26,941 in order to keep the age credit.
There are, of course, many other ways for seniors to reduce the impact of income tax; ultimately, the suitability of any strategy depends on your personal situation, and some may be too complex and costly for your situation.
Joel L .Rubinovich is Senior Partner of Toronto accounting firm Rubinovich Newton. He has been in practice for over 45 years and is an expert in the financial- and tax-planning areas, specializing in seniors’ taxation matters.