December 06, 2011

Year-End Tax Planning

Making a List & Checking it Twice

The month of December brings on challenges for procrastinators in a race to ensure the last deadlines of the year are met. To help alleviate some of the stress of the holiday season, we have compiled a list to help ensure your financial affairs are organized at year-end, so that friends, family and charities benefit, rather than the tax authorities.

Naughty & Nice Ways to Pay for an Expensive Month

Whenever you tap your investment portfolio for holiday spending, a tropical vacation, or any other cash need, ensure that you raise the money in a tax-efficient manner.  After cash in the bank, your Tax Free Savings Account (TFSA) should be the next best source of funds, and December is the most advantageous month to draw from it.  The money taken from a TFSA can be replaced entirely in January 2012, along with your new maximum annual contribution, so the impact of withdrawing money from this tax-sheltered account is minimal.

A taxable portfolio of securities is a less desirable source of cash because capital gains will be triggered if the securities sold to raise it have appreciated in value.  On the other hand, if you own a security that has declined in value below its cost base, the loss triggered by its sale can be applied against capital gains on your prior three tax returns, or carried forward against future capital gains indefinitely.  However, if you buy back the same security within 30 calendar days the loss will not be allowed by the Canadian tax authorities (CRA).  Also note that, ‘tax loss selling’ must be done by December 23 to be applied to the 2011 tax year.

If you are 71 or older, a Registered Retirement Income Fund (RRIF) may be the next best source of cash as a minimum income withdrawal is required each calendar year after age 71.  If you have not drawn out your minimum by December, it will be paid to you by year-end.  If you decide to draw out more than your minimum be aware that withholding taxes will apply to the amount withdrawn in excess of the minimum.

Typically, the least desirable source for short term cash needs is a Registered Retirement Savings Plan (RRSP) because cash withdrawals can’t be replaced. This will result in both a high tax cost and the benefit of tax-sheltered assets is lost.

Give the Gift of Education

Parents and grandparents can fund a Registered Education Savings Plan (RESP) for post-secondary education for their children and grandchildren. The Federal Government provides a 20% grant each calendar year, so ensure that the maximum is contributed by December 31 to receive your benefit.

Support Those in Need

Making a cash donation to a charity from an investment portfolio has the same tax implications outlined above, and careful attention must be taken to avoid triggering a tax bill.  Donating an appreciated security is a tax-advantageous gift because you avoid capital gains tax and enjoy the benefit of a tax deduction for the full value of the security.  A stock with a large capital gain that you were thinking of selling is the perfect candidate for donation. Act at least two weeks before the end of the year to ensure that all of the paperwork between your investment manager and charity can be completed in 2011.

Reduce Your Gift to the Tax Collector

Year-end is also an appropriate time to review the account structure of your portfolio to ensure that investment returns are being received in a tax-efficient manner. Generally, investments paying interest income should be in tax-deferred accounts (RRSP, RRIF and TFSA) and investments that generate dividend income (especially Canadian) and deliver capital gains should be in taxable portfolios (personal or corporate). Additionally, U.S. assets should be held as ‘Canadian,’ either through a Canadian mutual fund or a corporate account, to avoid U.S. estate taxes.

Don’t Forgot About Your Accountant

Determining your investment income before the end of the year can give you a head start on planning for tax season. If you own stocks and bonds it is a simple calculation to add up your interest income, dividends received and realized capital gains in the year. If you own pooled or mutual funds, ask your fund manager for an estimate of the year-end distribution.  Knowing the numbers will help your accountant determine whether OAS clawbacks may occur next year and if the timing of income recognition or withholding tax may be appropriate.  Estimated year-end mutual fund distributions can also be useful when planning the timing of future mutual fund purchases. Finally, ensure that you make deductions for all allowable expenses when preparing your tax return.  For example, investment counsel fees paid on taxable accounts are deductible, as are interest costs.

A Good Investment can be a Gift that Keeps on Giving

At this time of year, our attention can be diverted from our ultimate investment goals by the myriad of tax-driven investment products on offer. Despite the theme of this list, never make an investment based solely on its tax benefits. All investment decisions should be driven by you or your advisor’s view of the value of the underlying security and its suitability relative to your long-term investment objectives.

This article is not intended to provide advice, recommendations or offers to buy or sell any product or service. All tax decisions should be made after discussing your individual positioning with a qualified tax accountant, as everyone’s tax situation is unique. The information provided in this report is compiled from our own research and is based on assumptions that we believe to be reasonable and accurate at the time the report was written, but is subject to change without notice.