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Tax-Free Savings Accounts allow you to save for many purposes, including shorter term savings goals such as buying a home or new car and longer term savings goals such as saving for retirement |
Review the mix of investments in your portfolio
Each type of investment income is taxed differently. Most interest must be accrued annually and is fully taxed. Dividends are only taxed as received and are eligible for a dividend tax credit. Capital gains are taxed when realized and, with a capital gains inclusion rate of 50%, were generally taxed at a lower rate than dividends. However, the capital gain vs. dividend comparison changed significantly in 2006 as the changes in the taxation of dividends significantly lowered the tax rate that applies on eligible dividends. Now the tax rate on eligible dividends is lower than the tax rate on capital gains in some provinces.
In general, most dividends paid by a Canadian public company after 2005 will be eligible dividends. These dividends will be subject to a 41% gross-up in 2011 (rather than the 25% gross-up that continues to apply for ineligible dividends) and are eligible for a higher dividend tax credit (for 2011, approximately 16% of the taxable amount federally vs. 13 1/3% for an ineligible dividend). Most provinces have also introduced a higher tax credit on eligible dividends. Note that with federal corporate tax rate reductions being phased in until 2012, there will be adjustments to the eligible dividend gross-up and dividend tax credit rates until 2012 that will increase the tax rate on eligible dividends.
Year-end is an excellent time to review the mix of investments in your portfolio to ensure that you’re getting the best returns on an after-tax basis.
Consider the timing of the taxation of interest earning investments
Interest on investments purchased after 1990 must be accrued annually on the anniversary date of the investment, unless you receive the interest more frequently. For instance, interest on Canada Savings Bonds (CSBs) purchased on November 1, 2010, must be accrued as at October 31, 2011 and included in 2011 income. This applies even if you have not yet received the interest, such as with compound interest CSBs.
Also, some investment products pay interest at increasing rates over the term of the investment. For tax purposes, you may find that you must report the interest at an “average rate,” with higher income recognized in the earlier years, when the actual interest received is lower.
Be sure to take into consideration the timing of the receipt of income and the tax consequences when investing. Also, if you’re thinking of purchasing a one year Guaranteed Investment Certificate towards the end of 2011, you may want to consider delaying the purchase to early 2012 to defer the recognition of the income to 2013.
Review your outstanding debt to ensure that you make your interest expense deductible to the maximum extent possible
To be deductible, interest expense must relate to debt incurred to earn business or investment income. Interest on personal debts, such as mortgages or car loans and interest incurred to make RRSP contributions, are not generally deductible. Another point to keep in mind is that investment income doesn’t include capital gains. The CRA takes the position that interest on funds borrowed to invest in assets producing only capital gains isn’t deductible.
Review your loans outstanding at year-end and your overall cash position. Where possible, pay off non-deductible debt as quickly as possible. Avoid using excess funds to pay off business or investment loans, if you know you will have to make large personal expenditures in the near future. Where you have a choice, always borrow for investment or business purposes over personal uses.
Also, note that where you’ve sold an investment at a loss and continue to carry debt incurred to purchase the investment, you should leave these loans outstanding as long as you have other non-deductible debt that could be paid off first. Interest from debts relating to the loss on an investment (other than real estate or depreciable property) continues to be deductible as long as those debts remain outstanding and all of the proceeds from the loss asset are reinvested.
Consider delaying mutual fund purchases
If you’re considering purchasing units of a mutual fund, you may want to defer the purchase until early 2012 (or later in December 2011). Many mutual funds (and most equity funds) distribute income and capital gains once a year, during December. Consequently, if you purchase units of these funds just prior to a distribution, you will be allocated a full share of the mutual fund’s income and gains for that year. Deferring the purchase until after the mutual fund distribution will ensure that you won’t be allocated taxable income for 2011.
Consider using your Tax-Free Savings Account
Since January 1, 2009, you have been able to incorporate the use of a Tax-Free Savings Account (TFSA) into your mix of investments. TFSAs allow you to save for many purposes, including shorter term savings goals such as buying a home or new car and longer term savings goals such as saving for retirement.
Canadian residents 18 years of age or older can open up a TFSA and contribute amounts to the TFSA up to the contribution room available. You will acquire a $5,000 contribution room every year (which will be indexed to inflation and rounded to the nearest $500 on an annual basis). Any withdrawals made in the previous year as well as any unused contribution room from the previous year will be added to the contribution room for the current year. A TFSA is generally permitted to hold similar investments to those of an RRSP, including mutual funds, publicly traded securities, GICs, bonds and certain shares of small business corporations. However, there are specific rules that will limit investments that are not available on the open market. In particular, the rules on private company investments are quite restrictive. You will be subject to penalties on any investments which are not permitted to be held in your TFSA.
In 2010, a number of TFSA contributors were identified by the CRA as having made possible excess contributions to their TFSA. For many, this was because they had either used their TFSA as a savings account (moving funds in and out of the account repeatedly) or had moved amounts between plans without a direct transfer. In order to avoid making excess contributions to your TFSA and subjecting the excess balance to a penalty by the CRA, you should consider your timing when replacing TFSA funds withdrawn and ensure that direct transfers between your TFSAs are reported properly by your financial institution(s). It is worth noting that TFSA overcontributions will be subject to a penalty tax for excess contributions, calculated at 1% per month on the highest amount of excess TFSA contributions in that month. For a more detailed discussion of the problems associated with overcontributions to a TFSA and tips on how to avoid this problem, see the article “Tax-Free Savings Accounts: A Refresher” in our Tax Factor 2010-03 publication.
For 2009 overcontributions, the CRA put a process in place to review each situation on a case-by-case basis, and where appropriate, waived the penalty for excess contributions for those overcontributions that arose due to a genuine misunderstanding of how the TFSA rules worked. On August 19, 2011, the CRA announced a similar relief program for 2010 overcontributions – see our Tax Factor 2011-03 article “TFSA Update”.
While contributions to a TFSA will not be tax deductible, income, losses and gains in respect of investments held within a TFSA, as well as amounts contributed, will not be included in computing income for tax purposes or taken into account in determining eligibility for income-tested benefits or credits.
Generally, if you make an interest-free loan or gift funds to a spouse to invest, the income on the investment will be attributed to you and taxed in your hands. In the case of funds used by your spouse to make a TFSA contribution, there will be no taxable income, and therefore, the attribution rules will not be a concern. The same will be true where you make an interest-free loan or a gift to an adult child so that they can invest in a TFSA. Loaning or gifting money to family members to contribute to a TFSA will be an important personal tax planning consideration.
For more information on TFSAs, read our Answering Your TFSA Questions bulletin.
Next section: Capital gains and losses
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