The 6D Tax Planning Approach

May 18, 2018

I am told that the full version of our Federal Income Tax Act is more than 3,000 pages. I don’t believe it. If you’ve ever tried to look something up on the CRA website, you’ll understand that it has almost infinite dimensions! This also does not account for the various provincial tax regimes.

Although we have what is known as a “Voluntary Compliance” tax system, it is important to understand that this does not mean it is optional!

Most of us love to hate our tax system! It’s very complex and its effects become more and more painful as our wealth and incomes climb. It is however a necessary part of a well-functioning country and supports the governance, services and infrastructure necessary for a high-functioning economy. However, that does not mean we should be overly generous in the tax we pay!

I am not advocating tax-evasion. There are an abundance of legal ways to reduce our tax burden. I refer to these strategies under the following categories, better known as The 6Ds:

Deduct
Disappear
Defer
Divide
Discount
Donate

Deduct

A deduction does not directly reduce our taxes. Rather, it reduces the income that is exposed to taxes (taxable income). Typical deductions include the following:

Employee Pension plan contributions
Registered Retirement Savings Plan (RRSP) contributions
Carrying Costs incurred to service your investments. This could include interest expense, investment counsel fees and safety deposit box fees.
Union/professional association dues
Alimony/maintenance payments
Employment expenses
Moving expenses
Professional fees
Child care expenses

This is only a summary list. You should consult your tax advisor to make sure you qualify for such deductions.

Disappear

Okay, I’m not suggesting that you skip town. I’m recommending that you make the tax disappear by making maximum use of strategies that are actually totally tax-free. These can include:

Principal residence exemption – As you probably know, there is no income tax payable when you eventually sell your own home for more than you pay for it. This can be especially useful in the future if you decide to downsize and invest the extra equity for retirement income or other purposes.
Tax-Free Savings Accounts (TFSA). TFSAs allow for tax-free growth and tax-free withdrawals. I usually place it second in priority to RRSPs because you don’t get a deduction.
Reduce Spending – this is pretty simple. By making responsible buying decisions, you can eliminate GST, HST and PST taxes on unnecessary expenditures.

Defer

Deferrals allow you to delay the taxes due on the growth of your investment. I know it’s not always wise to delay the inevitable, but delaying taxes can actually work in your favour for a few reasons:

While the money is growing tax-deferred, you get the full effect of compounding without the drag of paying taxes on your growth every year, even though there will be taxes owing when you sell the investment.
You have a lot more control over when to pay the taxes.

Some common tax deferral tools include:

Registered Retirement Savings Plans (RRSP)
Registered Retirement Income Funds (RRIF)
Registered Education Savings Plans (RESP)
Pension Plans
Long term equity investments including investment real estate, stocks and mutual funds or Exchange Traded Funds (ETFs) with low portfolio turnover.

Divide

This is often called “income splitting.” For instance, the tax bill between a husband and wife will be lower if both are earning $50,000 rather than one spouse earing $100,000. What we want to achieve here is spreading out taxable income so as to take advantage of several lower tax brackets to relieve the tax impact of too much income falling on the shoulders of one person. CRA has been clamping down more and more on these strategies but there are still a number of effective ones left:

Spousal RRSPs help split income in retirement, although pension income splitting has made them less necessary.
Splitting CPP retirement benefits with the spouse with a lower expected CPP income.
Making full use of the RESP which essentially defers taxation on the growth and grant income to the student when he/she takes it out for post-secondary tuition expenses. Since students generally earn little income, the tax impact should be minimal.
Paying of wages to family members through a business. This is only legal if the family members are actually working in the business and are being compensated at wages that are within reasonable range for their roles.
Use of corporations to divide income among family members who are actively involved in the business.
Division of cash flow – Higher income spouse pays the bills – lower income spouse invests.
Loan money to lower income spouse to invest. Recipient spouse pays interest at the Bank of Canada rate. The higher income spouse can give money to lower income spouse to pay the interest.
Invest the Canada Child Benefit into an “in-trust” account in the child’s name. Interest and dividend income gets taxed in parents’ hands but capital gains gets taxed in child’s hands.

For many of these strategies, it is crucial to keep meticulous records in event of an audit.

Discount

This involves the use of “discounted dollars” in the form of permanent life insurance plans to pay for the deferred tax liabilities we build up while we’re living.

We know that there is often a substantial tax bill awaiting our estates when we die. Even though our wealth can transfer tax-free to a spouse, the tax bill must eventually be paid.

Because the timing of our departure is uncertain, it can be a good idea to use certain permanent life insurance policies to effectively pay pennies on the dollar through the life insurance premiums with the comfort that a large amount of tax-free cash will be paid to your heirs in order to pay the income taxes due upon your death.

Donate

This is one tax strategy that will financially benefit charitable organizations that you care about and reward you through a very generous charitable tax credit. Rather than a deduction which acts to reduce your taxable income and thereby generate a tax saving, a charitable tax credit acts to reduce the tax you pay through a charitable tax credit.

Since high income earners also pay the highest rates of tax, they also receive the highest reward for their generosity. For incomes well in excess of $205,842 a $10,000 charitable donation for taxpayers in British Columbia could result in a $4,980 tax credit.

A further tax incentive awaits those who donate shares and other capital property. In addition to the charitable tax credit, they also do not have to pay capital gains tax on the embedded growth in the property being transferred.

What Next?

You might want to play with a few of the following calculators which incorporate tax planning principles:

The basics of tax planning can be largely achieved on your own. If you want to take it to the next level though, you will need to build these strategies into your financial plan with the right group of advisors.