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Controlling when you take your income and deductions can shave tens of thousands of dollars off your tax bill during your lifetime

round this time of year, most of us are scrambVng to make an RRSP contribution so we can get a nice fat tax refund. How­ever, savvy investors who understand the

tax system take a different approach. By planning ahead, they're able to take ad­vantage of sophisticated strategies that will amplify their tax savings in the years to come. They do it by using a tactic called

"income smoothing." The general idea is that when you're in

yciur high earning years, you want to take maximum advantage of tax deductions and defer some income so you can avoid paying tax at a high rate. When you're in your lower earning years, that's the time to take extra income, as you'lllose Jess of it to tax. This works best when you remain in the same tax bracket, because if you push yourself past the threshold, you'll pay more tax on each additional dollar earned.

These techniques are commonly used by tax experts and wealthy individuals, but many of the concepts work for regular folks, too. Manage your taxable income properly and you can shave tens of thousands of dollars off your tax bill during your lifetime.

The idea of controlling your income may sound far-fetched if you're a salaried worker who doesn't have the ability to choose when or how much you are paid. But even the simple RRSP, when used prop­erly, is an income-smoothing strategy. Say you're in mid-career bringing in a salary of $80,000. If you're a B.C. resident and you make a $10,000 RRSP contribution, you'll save $3,185 in taxes. But what some inves­tors forget is that the RRSP allows you to defer taxes, not avoid them. When you retire, you'll be taxed when you pull that same $10,000 out of your RRSP. (At that point, it will likely be in the form of a Registered Retirement Income Fund, or RRIF.)

However, paying the tax later is actually a big benefit if, like many seniors, you're in a lower tax bracket in retirement. If you have an income of $30,000 at that point and you take an additional $10,000 from your RRIF, you'll pay just $2,108 of tax on it, for a savings of more than $1,000.

Other income-smoothing strategies, such as investing in flow-through shares and the timing of capital gains, are more complicated, but they all rely on the same basic idea of smoothing your income and deductions to reduce the total amount of tax you have to pay.

UNDERSTANDING TAX BASICS

The first thing you need to understand is how tax brackets work. You don't pay a dime on the first $10,000 or so that you earn. Then you pay around 20o/o in com­bined federal and provincial or territorial tax on the next slice of income between $10,000 and $39,000 (figures vary in each province and territory). As you make more money, the percentage of tax you pay on each additional chunk of income gradually rises, until you're paying approximately 4So/o on the last portion. The rate you pay on the last dollar you earn is called your marginal rate.

During periods of your life when your taxable income is low, your marginal rate is also low. If you have a choice, this is gener­ally a good time to take more income, as you'll pay less tax on it. However, it's not the greatest time to make an RRSP contri­bution or take other deductions, because you won't save much in taxes.

When you're in a higher tax bracket, you pay more tax, but you also save more when you make a deduction. This means that if you.can take a dollar you would have made in a high-earning year and add it to your taxable income in a low-earning year, you'll reduce the percentage of that dollar that is taken by taxes. As long as you're not in the same tax bracket throughout your life-and few people are-then you have some ability to take income and use deductions at times that will result in an overall tax savings.

How do you know what tax bracket you'll be in years from now? You can't be sure, but proper financial planning can give you a good estimate. Most people start their careers at lower salaries, moving up in income as they gain experience. Life events such as maternity leaves, layoffs, and sabbaticals can create opportunities to take advantage of being temporarily in a low tax bracket. The years approaching retirement also provide opportunities to make the most of changing rates. By thinking about your tax situation in the future-and not just on April 30 of this year-you will be able to hang on to more of your lifetime income.

< RRSPS CAN WAIT

Young people are bombarded with advertise­ments and well-meaning advice from friends and family urging them to get started on their RRSPs as soon as possible, but there's no need to rush. Saving is always a good idea, but if you're just getting started on ,..

FE BRUARY/M ARCH 2012 I MoneySense.ca 33

• PLANNING

your career, it's better .from a tax point of view to delay contributing to an RRSP until you're a bit older and are making a higher salary. (See "Maximize your RRSP," p. 24.)

This was the thinking of Wallace Hui, a Toronto resident who works in the financial industry, when he was in university a few years ago. Although he had a part-time job as a tutor and could have contributed a bit of money to his RRSP, he decided to wait until he was in a higher tax bracket so he would get a bigger deduction. Now that he's working full time and making around $38,000, he plans to make a small RRSP contribution-just enough so he'll get the GST/HST credit.

"I'm in a junior role, so I'm hoping that I'll get some promotions and make more money as time goes on," says Hui. "Right now I'll bring my income down a bit so I'm eligible for some government benefits, but I'll save the rest of my RRSP room for my higher-income years." In the meantime, Hui is saving money inside his TFSA.

According to Ross McShane, director of financial planning at McLarty & Co in Ottawa, Hui is smart to save the bulk of his RRSP room for the future. "If you know your salary is going to go up, hold off contribut­ing to an RRSP and concentrate on paying down debt," he says. "Once your debt is minimized, you can use your RRSP room later and get a bigger bang for your buck in terms of the tax deduction."

) RRSPS AREN'T JUST fOR RETIREMENT

If you're having a year or two where you're making much less money than normal-say you're on maternity leave, you lost your job, or you're backpacking around Asia-you might want to think about pulling some money out of your RRSP. This may sound sacrilegious to many financial planners, who insist you should never tap your RRSPs dur­ing your working years. But in some cases, the savings on income tax is so sweet that it's worth it.

"The RRSP is misunderstood as being an account that is meant solely for retirement," says Jason Heath of E.E.S. Financial Services in Markham, Ont. "I look at it as a tax-deferral and planning vehicle."

For example, say a woman is on mater­nity leave, doesn't qualify for Employment Insurance and has no other income. She could pull some money out of her RRSP to help cover expenses. "If she took out around $10,000-the amount of your per­sonal credit-she wouldn't pay any tax on it," says Deborah MacPherson, a Calgary-

34 MoneySense I FE BRUARY/M ARCH 2012

based partner at KPMG. If she took out a few thousand more, it would still be taxed at a low rate, possibly lower than she would pay in retirement.

Note, however, that when you make an early withdrawal from an RRSP, you're subject to a withholding tax of 10% to 30%. You can get that money back when you file your tax return, but you need to plan ahead. (The withholding tax does not apply if you're borrowing from your RRSP as part of the Home Buyers' Plan or the Lifelong Learning Plan.) J TBE DARK SIDE

OI'RRSPS

Sonia Macintyre, a 55-year-old who lives in Ormstown, Que., has only $14,000 in her RRSP, so when she learned a few months ago that she would receive a $170,000 in­heritance after her mother passed away, she thought she would make use of her unused RRSP contribution room. Macintyre (we changed her name to protect her privacy), who makes $36,000 a year, hopes the in­heritance will allow her to retire at age 60 so she can pursue her dream of travelling the continent in her motor home.

But while Macintyre would enjoy some tax savings from deducting her RRSP con­tributions, she can only reduce her taxable income to zero in any one year-any con­tribution beyond that would earn nothing. What's more, in her case the RRSP's tax de­ferral might be insignificant because she is already in the lowest tax bracket (29%) and will pay tax on future withdrawals at the same rate, or even a higher rate, depend­ing on the amount she takes out in a given year, says Heath.

"Another drawback for Sonia," he says, "is that the RRSP withdrawals are likely to limit her entitlement to the Guaranteed Income Supplement for low-income seniors at age 65, as well as limiting other federal and provincial tax credits." (For more, see

"Finding hidden money," p.l8.) Instead, Heath advises Macintyre to use

the inherited money to pay off her mortgage and to max out her TFSA. Any remaining funds could be invested in Canadian divi­dend-paying stocks-at her current salary, Macintyre would pay just 6% tax on the income, thanks to the dividend tax credit.

Similarly, people with higher incomes who are heading toward retirement face the risk of losing their Old Age Security (OAS) benefits, which are paid out to qualifying Canadians beginning at age 65. The prob­lem is that at when they turn 71, seniors are forced to convert their RRSP into a RRIF or a

registered annuity. A RRIF, the most popular option, requires you to make minimum withdrawals each year. That money must be reported as income, so it can knock seniors into a higher tax bracket and put them at risk of losing their OAS, which starts getting clawed back at $67,668 and is completely wiped out at $110,123.

For all these reasons, sometimes it's bet­ter to take some of your RRSP money out before you turn 65. You'll take an initial tax hit, but it may be less than you would pay in retirement if you factor in the loss of government benefits. If you're approach­ing retirement, ask a financial planner to run through some scenarios with you, or crunch some numbers yourself by using the calculators at TaxTips.ca.

If your spouse is younger than you, there is a trick for extending the tax deferral of savings held within a RRIF. You are al­lowed to base your minimum annual RRIF withdrawals on the age of your spouse. No, this doesn't mean we're advising you to seek out a much younger mate as you ap­proach the mandatory age. But by tying the withdrawals to your partner's age, you can keep the money sheltered in the RRIF longer if you want to. "It gives you a little more flexibility and puts you in control," says McShane.

MAKE TBE MOST C) 01' SEVERANCE ~ AND MOVING EXPENSES

If you get laid off and you're offered a sev­erance payment, consider the tax implica­tions before you agree to anything. Ross McShane has a client who was laid off near the end of 2011. As he was in the 46% tax bracket, he was set to lose almost half of the severance to taxes. There's a good chance that the client won't be earning much this year, so McShane advised him to ask his employer to make the severance payment on January 1, 2012. "It's a $100,000 sever­ance, so if he takes it when a good portion is taxed at 20% to 24%, he would save around $18,000 in tax."

Similarly, if you have moving expenses related to a new job, you can take advan­tage of the two-year window to claim the deduction. For example, if you moved to take a new job with a bigger salary, you'll get a larger deduction if you claim your moving expenses in the following year. This deduction can be big, as you can include travel costs, meals, lodging, real estate com­missions and legal fees. Note that you must move at least 40 km to be closer to your new job to be eligible for this deduction.

. I

I

G) SE'n'ING UP ~ A CORPORATION

One of the best ways to control when you receive income is by setting up a corpora­tion. This option isn't for everyone, but the red tape and legal fees can be worth it if you're making $90,000 or more in after-tax self-employment earnings and you're not spending it all. "A corporation allows you to control when you take personal income," says McShane. "It's a wonderful opportunity to lower and defer tax across the family."

Incorporating was a great move for Malcolm Wilson, a 60-year-old internal medicine specialist in Huntsville, Ont. He'd already saved a large sum in his RRSP and wanted to keep working. Now all the money he earns goes into his corporation and is taxed at a lower corporate rate. He takes a modest salary from the corporation­around $48,000 a year-and invests the rest inside the corporation. "It's like having a second RRSP."

Wilson can control the timing of when he takes out the rest of the money, and he can pay himself in dividends, which are taxed at a lower rate than salary. Plus, he can cut the family tax bill even more by pay-

ing dividends to family members in lower tax brackets. "It almost sounds like money laundering, but it's legal," Wilson laughs.

~ INCOME SMOOTHING YOUR PORTI'OLIO

Your choice of investment type can cre­ate opportunities to control the timing of your income. For example, if you're in the high earning years of your career and you don't want to increase your taxable income, avoid holding dividend stocks and bonds outside of your RRSP and TFSA. That's be-

cause dividends and interest are taxed in the year they are received and will boost your taxable income. Instead, you might want to focus on growth stocks that don't pay dividends: that way you won't pay tax on the gains until you sell, and the capital gains are taxed favourably. "In some cases, you can time that capital gain to a low­income year, or spread it out over a period of years," says Heath.

Capital losses can also be used to offset realized capital gains. So investors with capi­tal tosses on paper can sell those investments in years when they are in a high tax bracket, which allows them to save more tax than in lower-income years. You have to use capital

losses to offset gains in the same year, but you are allowed to carry back additional losses and apply them to gains realized in the three previous taxation years, or carry forward the losses indefinitely. "If you were in a low tax bracket in the previous years, it may be advantageous to save the capital loss for a future year," says Heath.

J GO WITH THE FLOW-\Q THROUGH SHARES

Flow-through shares were created to spur investing in the mining and energy sectors. The idea is that an exploration company with high expenses but little income can flow its losses through to investors. Flow­through shares are often used by wealthy investors who have run out of RRSP contri­bution room. "They're risky, because you're investing in penny stocks," says Heath. "But in a lot of cases, a flow-through share will allow you almost a 100% tax deduction."

This is how it works: If you're in the top tax bracket and invest $10,000 in flow­through shares, you get a tax refund of al­most $5,000, plus another $2,000 in tax credits, which means you would have ef­fectively paid $3,000 for $10,000 worth of shares. You typically aren't allowed to sell the shares for two or three years, and you eventually pay capital gains tax on the en­tire value of the stock when you sell. If the shares stay at the same price, you'll make money. However, the value of these risky investments can easily go to zero, meaning you can lose money despite the tax savings.

G) DON'T FORGET \?d THE BIG PICTURE

While these tips can potentially save you a pile of money, remember to never take on an investment or a strategy solely because of the tax benefits. "First and foremost, you need to look at your objectives and risk tol­erance," says McShane. "If the investment fits your needs, then take a look at it from a tax perspective."

Countless investors have become so enamoured with the tax benefits of risky investments and tax shelters that they've failed to realize that an inappropriate gamble can cause you to lose a much bigger chunk of your money than you would have paid to the tax man.

Always make sure you understand your broad financial picture before you delve into complicated tax strategies. With a strong sense of your priorities and an eye to the future, you'll be well positioned to maxi­mize your after-tax income and meet your financial needs in the years to come. I M

FEBRUARY/ MARCH 20 12 I MoneySense.ca 35