Q. I’ve done some research into tax-enhanced investment options, including corporate-class or swap-based funds, investments that pay a return of tax-free capital, flow-through shares, and life insurance strategies to help reduce taxes. When should someone consider these investment options and how do they determine which one is best for them?
A. Lou, my first thought is don’t participate in any “tax-enhanced investment” options until you have maximized your RRSP* and TFSAs* and, if you have children, RESPs. Each one of these vehicles allows your money to grow tax-free, and each is relatively simple to participate in.
I’d also caution you not to invest in any “tax-enhanced investment option” until you’ve modelled it in financial planning software that accurately illustrates your current and future cash flow. (A financial planner can help.) This means a little work for you to get your numbers together, but once you do, you’ll be able to:
- Confirm the strategy will work as expected;
- Compare other solutions to measure the risk/reward tradeoff; and
- Have confidence and feel good about your decision.
Using software to model the concept only may be misleading. Concept software is useful to simplify and explain a strategy, but it rarely gives the big picture, which is what you need to make a good decision. It is not uncommon for a tax strategy to look good in isolation, but not so good when future cash flows, taxes and lifestyle changes, are factored in.
When you’re initially thinking of “tax-enhanced investment options,” ask yourself these questions which I have organized around the four categories of accumulation (your working and earning years), decumulation (retirement), estate transfer and need.
- What is my marginal tax rate and what can I do to move down to the next lowest marginal tax rate?
- Will reducing my taxable income make government benefits available to me? Examples include the Canada child tax benefit, caregiver credit, student loans and grants for children, and the GST/HST credit
- Does it make sense to defer the tax now and pay the tax later? What will my future marginal tax rate be? Will deferring tax affect future government benefits and credits?
- What will I do with the tax savings? Will I re-invest the tax savings into my wealth building program or enhance my lifestyle? This is where investors lose the true value of tax strategies—by not reinvesting the tax savings/deferral back into their wealth building program. Remember, there is nothing wrong with spending the tax savings on your lifestyle as long as you know, and are happy with, the long-term implications. It’s your money and your life.
- Can I combine tax strategies? For instance, maximize RRSP contributions and use the tax refund for TFSA contributions and/or RESP contributions?
- What can I do to lower my taxable income, and what government benefits, if any, will be available to me? Examples include OAS clawback, GIS benefit, age credit, caregiver credit, etc.
- What is the most tax efficient way to transfer my assets to my beneficiaries?
- If I can maintain my lifestyle throughout my lifetime, so do I want to take the extra risk, possibly jeopardizing my lifestyle, to try to save some tax?
- If I am single with no dependents, is life insurance really the best solution? (This is just an example; there may be a need where insurance makes sense for a single person.)
Lou, I am going to stick with my original statement. See what you can do with RRSPs, TFSAs, and RESPs (if applicable) first, and then look toward tax-enhanced investments. I strongly encourage you to see how the strategy works using proper planning software with itemized cash flow projections. If you really feel you have a need for tax-enhanced investments, visit a financial planner, who can help to guide you through the investment selection process, which will be based on a number of things, including your stage of life, taxable income, and whether it is personal or corporate taxes you’re trying to save.
Allan Norman is a certified financial planner and Chartered Investment manager in Barrie, Ont. Allan can be reached at [email protected]
This commentary is provided as a general source of information and is intended for Canadian residents only. Allan offers financial planning services through Atlantis Financial Inc.
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