South of the border the trend under the administration of Donald Trump is towards lower taxes. But here in Canada, high-income investors and modest-income retirees and would-be retirees are looking with trepidation to the March 22nd federal budget.
Last year, the federal Liberals introduced minor cuts to income tax levels for the middle class while pushing the top combined federal/provincial marginal tax rate past the magic 50% in several provinces, including Ontario, where the figure is now a whopping 53.53% (including high-income surtaxes) for those earning $220,000 a year. In other words, when such a high-earner receives a cash bonus on top of the regular salary, those “last” dollars will be taxed at 53.53%, as would interest income in non-registered investment accounts.
Now it’s true that anyone interested in this regular Retired Money column is well aware that capital gains and dividends are taxed less harshly than earned income, bonuses or interest. According to this article at TaxTips.ca, in that top tax bracket the same person would pay just 26.76% on capital gains, although I was shocked to learn that the rate on eligible Canadian dividends is a rather stiff 39.34% (in the highest tax bracket).
I say shocked because most Canadian taxpayers have a fond notion that the tax rate on such dividends is closer to 25%. It is in fact 25.38% but only for those in the tax bracket of $91,831 to $142,353 (2017 figures).
Fortunately – unless as some fear the upcoming budget changes all the rules again – taxes on capital gains and dividends are more merciful for those earning under $90,000 a year. And I’m guessing that includes a lot of semi-retired and retired people who now rely on some combination of pension income and investment income.
You may have seen stories elsewhere about the fact citizens of a number of Canadian provinces, including Ontario and most of the western provinces, can earn up to $50,000 a year in eligible dividend income and pay almost no tax. That’s true but only if you keep in mind the critical qualifier: that you have no other major sources of income. So if you’re making good money as an employee, this strategy won’t help much, nor will it greatly help if you enjoy generous pension benefits. Plus, says Vancouver-based portfolio manager Adrian Mastracci of Lycos Asset Management, you’d have to amass roughly $1 million in a non-registered stock portfolio to generate $40,000 a year in eligible dividend income (assuming 4% yield), a figure that is then “grossed up” by 38% in accordance with Ottawa’s bizarrely complex tax rules.
In a family situation where one spouse is the principal wage earner and the other is not employed, the dividend income on non-registered investments would normally be attributed back to the wage-earning spouse, says Aaron Hector, a certified financial planner with Calgary-based Doherty & Bryant Financial Strategists. However, he adds, if their affairs were structured so that a spousal loan was in place, then the non-registered investment income could be taxable to the non-working spouse. In this situation, the potential for the “$50,000 tax-free dividend income” is there so long as the proper planning is in place.
We’ve talked before here about “topping up to bracket” and the “tax-free zone” of roughly $20,000 that consists of the Basic Personal Amount, the $2,000 pension credit and the $7,125 Age Credit that kicks in at age 65. The latter has been flagged by some pessimistic observers as a possible victim of the budget. If so, it would be a terrible pity because in effect the Age Credit (which is means-tested) has the effect of making Old Age Security (OAS) income in effect tax-free: you can start to collect OAS at 65.
Certainly if you are post-employment and can defer pensions and RRSP/RRIF drawdowns in your 60s, the first $41,000 or so of qualifying dividend income qualifies as its own tax-free zone, or nearly so. According to Tax Tips, the sweet spot is the first $41,536 of taxable income: At that level, interest is taxed at 20%, capital gains at 10% and – believe it or not – eligible Canadian dividends are taxed at minus 6.8%. Even non-eligible dividends are taxed at only plus 6.13%.
Tax rates on eligible dividends remain reasonable until you reach $140,000 in taxable income. Between $41,536 and $45,282 (in 2016, it will be $42,201 to $45,916 in 2017) the tax rate on eligible dividends is minus 1.2%, then rises to a modest 6.39% between taxable income of $45,282 and $73,145 ($45,916 to $74,313 in 2017). Even when you reach the income at which OAS starts to get clawed back, the tax rate on eligible Canadian dividends is just 8.92% (for 2016 taxable income between $73,145 and $83,075.)
So when the budget comes down later this month, keep a close eye on tax brackets and on how capital gains and dividends may be taxed going forward. There has also been speculation about raising the capital gains inclusion rate from the current 50% to as high as 66.7% or even 75%. Hector says a proactive investor could trigger gains before the budget in the hope of cashing in at today’s lower rates but if such a measure doesn’t occur, you would have accelerated the payment of tax for no reason. So as always, it makes more sense to sell only if you need the money for some other purpose.
In short, we’re about to find out just how much the Liberal government really cares about middle-income seniors occupying the Retirement Risk Zone. Based on their early retrenchment of annual TFSA contribution levels (from the $10,000 the Tories introduced to the current $5,500), I’m not optimistic. Even pension income splitting has been cited as a possible target, which Hectors says would argue for taking advantage of spousal RRSPs, covered in this space last time.
One hopes the tax-cutting zeal going on in the United States will influence Ottawa but I wouldn’t count on it. Still, Patrick McKeough – whose TSInetwork.ca publishes the new Dividend Advisor newsletter — is confident that tax reform will go through in the U.S. “It will do wonders for the U.S. economy and stock markets. I also think the [Canadian] Liberals are going to have to follow if they want to stay in office.”
Jonathan Chevreau is founder of the Financial Independence Hub and co-author of Victory Lap Retirement. He can be reached at firstname.lastname@example.org