As a Canadian investor, taking the time to look at your finances and implementing some key strategies can go a long way when it’s time to file your taxes. You work hard for your money so it’s important that it’s not all lost to the tax man!
Let’s look at seven key tax tips in the article below.
Table of contents
- 1. Tax-Loss Selling
- 2. RRSP Contributions
- 3. The In’s and Out’s of Canadian RRSP Loans
- 4. Make a TFSA Contribution
- 5. Make RESP contributions and maximize your 20% grants
- 6. Ensure distributions for incorporated business owners do not fall afoul of new income splitting rules
- 7. Passive Investment Income
1. Tax-Loss Selling
The last few years have been a challenging but rewarding year for disciplined, long-term investors. Investors with non-registered holdings may have taken advantage of buying opportunities in earlier years. Or even the lows of March and April of 2020 and beyond, and be sitting on profitable capital gains positions. If you also have tax losses from other positions in your portfolio, it may make sense to consider a strategy called tax-loss harvesting. Tax-loss selling involves selling investments with an accrued capital loss position at year-end in order to offset capital gains elsewhere in your portfolio. Let’s review a few important tax tips for Canadian investors related to tax-loss selling.
What does tax loss harvesting mean?
Essentially, if you had an allowable capital loss in a year, you must apply it against your taxable capital gain for that year. If you still have an excess loss after doing so, it becomes part of the total of your net capital loss for the year. You can use a net capital loss to reduce your taxable capital gain in any of the three preceding years. Or in any future year. So while taking excessive losses might be emotionally difficult, it can be extremely lucrative over several different timeframes. Plus it can save you significant tax amounts. This is tax loss harvesting.
Is tax loss harvesting a good idea?
Consider an investor with two securities in a non-registered portfolio. Imagine that this investor has a portfolio with three securities, Securities A, B and C. Security A was purchased on January 1, 2023, and cost $500 plus $10 in fees. Several months later, the investment is doing great, and the investor decides to take some profits and sell the position for $910 in early February 2023. If the investor makes no further decisions until much later in the year and realizes that if there are no capital losses to offset this gain, they will have $200 added to their total taxable income for the year (half of the $400 gain). Luckily, the investor has some investments (B and C) with unrealized capital losses of $200 each. Reasoning that Security C is still a good investment with a strong potential to rebound in the years to come. The investor decides to sell Security B and realize a $200 capital loss to offset half of the gain from Security A.
Tax-loss harvesting for Canadian investors
One of the benefits to the Canadian tax system is that capital losses are available to any of the prior 3 years gains or carried forward indefinitely. As an example, in 2023 a hypothetical investor, Jane, sold two different securities. One of which resulted in a capital gains tax of $500 and another with an allowable capital loss of $1,000. After applying her allowable capital loss against her taxable capital gain, the investor has -$500 ($500-$1,000) of unapplied allowable capital losses. While she cannot deduct the $500 from other sources of income in 2023, the $500 becomes part of the total of her net capital loss for this tax year.
She can apply the net capital loss against her taxable capital gains in any of the 3 preceding years or in any future year. Jane then completes the section of her tax return that deals with potential sources of capital gains and losses (Schedule 3) and attaches it to her 2023 income tax and benefit return. This will ensure that her net capital loss of $500 is on the Canada Revenue Agency’s records.
How are capital gains taxed in Canada?
If you are selling securities that you would otherwise not be selling due to their long-term value. Beware of the “superficial” loss rules that apply if you sell at a loss and then re-purchase within 30 days before or after the sale date. Whether you make a repurchase within this time frame, or whether your spouse or an entity you control makes the purchase, expect to have your capital loss denied by the CRA. Including if you do so within tax-sheltered accounts such as an RRSP or TFSA. In the following section, we explore perfectly legal ways to avoid this issue while staying exposed to similar risk/reward factors represented by the security that was sold.
Consider ‘adjacent’ securities to maintain your market exposure
Consider an investor in RBC (RY) on the Toronto Stock Exchange. If an investor sold this security at a loss and is concerned about being out of the market for 30 days, they might wish to purchase a stock with similar risk factors to maintain a semblance of their prior equity exposure. All of Canada’s major banks are relatively highly correlated with one another.
Barring major events that are specific to a single bank, much of the risk factors in RY could be represented by exposures to other Canadian banks. The basics of this strategy also apply to other products such as Exchange Traded Funds, Mutual Funds with particular asset classes or style focusses.
Be sure to pay attention to the details and do your research. Talk to your advisor to ensure you are selecting reasonable substitutes. Moreover, be aware that there are no guarantees with this approach. Past correlations and similar trading patterns tell you only what has happened in the past. They are not a guarantee that the next 30 days could involve unprecedented moves from historical patterns.
Related Reading: General Tax Avoidance Rule
2. RRSP Contributions
Registered Retirement Savings Plan (RRSP) contributions continue to be a center piece for Canadian retirement savings and tax minimization strategies. For the majority of taxpayers looking to benefit from the deferral of current-year income taxes and the tax-free growth of their principal, RRSP contributions represent a wealth-maximizing strategy. Investors can wait until as late as March 1, 2024 to make RRSP contributions for the current tax year. But it is best to maximize time in the market and tax-deferral benefits by making these contributions earlier in the year, rather than later.
Earlier is always better & regular RRSP savers outperform procrastinators
Consider Jane and Jill, hypothetical RRSP investors who start investing when they are both twenty years old. Throughout a 40-year period of investing $10,000 per year in their RRSPs, Jane waits until the year-end to make her contribution, while Jill invests $833 each month. Assuming they both earn a 6% return, who ends up ahead?
Jane does well and ends up with $1,547,620, but Jill outperforms and ends up wealthier by $111,291. Why? Each year, small increments of her money ($833) start compounding earlier in the year. Whereas Jane’s money only starts working for her when she contributes it at the last possible moment.
This scenario also involves consistent compounding of each amount at 6% over time. In reality, markets fluctuate regularly. There are significant dollar-cost-averaging benefits for Jill’s strategy of diversifying the timing of her buying into the market throughout the year. Think of it as not trying to time the market top or bottom, but hedging your bets throughout the year.
3. The In’s and Out’s of Canadian RRSP Loans
|Example: BC Resident||Business As Usual Scenario||RRSP Loan Scenario ($20k)|
|RRSP Loan Amount ($20k)||$0||$20,000|
|RRSP Contribution ($20k)||$0||$20,000|
|Tax Amount Due (Tax %*Taxable Income)||$17,704||$12,021|
|Tax Refund Amount||$0||$5,683|
|Loan Interest Cost||$0||$600|
|RRSP Investment Return ($20k x 6%)||$0||$1,200|
|Net worth gain on a deferred basis||$0||$6,283|
For many Canadians facing the prospect of either not making their RRSP contribution or taking on an RRSP loan is a difficult one. Who wants more debt? However, debt incurred to generate long term assets with the added perk of a tax refund can be an excellent strategy. Let’s examine the situation for an investor with an $85,000 income who is considering the choice between taking on an RRSP loan to top up their RRSP by $20,000, or just leaving it until next year. Let’s further imagine that our investor is generally a “Balanced” long term investor with a 6% annual return and can borrow at today’s low interest rates of 3%.
Related Reading: The 4% Withdrawal Rule Demystified
Do Canadian investors need to pay income tax on investments?
RRSP holdouts sometimes complain that, “RRSPs are taxable eventually so what’s the point?!” While true, this complaint ignores the wisdom of deferring dollars that must be paid until as far into the future as possible. Plus the very likely scenario for most Canadians that the prevailing marginal tax rates in retirement are lower than those during contributors working lifetimes.
Considering Jane and Jill, and whether Jane would have preferred to pay tax in 1960 or 2020? A dollar in tax paid in 1960 would require $8.80 in 2020 dollars. By deferring the tax all these years, Jane gets away with only paying $0.11 in 1960 dollars for each $1 in tax that she pays on RRSP or RRIF withdrawals today. (Source: Bank of Canada inflation tax calculator)
4. Make a TFSA Contribution
When TFSA’s were first rolled out in 2009, some Canadians doubted that they would become a significant part of their investment and retirement planning. Fast forward to today and Canadians who have been eligible that entire period would have $88,000 available to shelter income from tax. Many Canadians who have invested in long-term portfolios from the beginning boast portfolios well into the six figures now. Sizeable amounts that can have a tremendous impact on future goals and planning. For the 2023 tax year, the TFSA contribution room is $6,500.
TFSA – Withdrawals and Re-contributions?
TFSAs allow tax free withdrawals and re-contributions of those same amounts. Although, make sure you stay under your total TFSA contribution room within a single tax year. Don’t make the mistake of completing multiple transactions in a single tax year and breaching the upper limit on their TFSA limit by accident.
For example, let us say our investor Jill, who has been eligible for a TFSA since 2009 decides to take advantage of the account in March 2023. She funds the account with $10,000. Later in the year, in September, she decides to withdraw $10,000. Then, in December 2023, she re-contributes back the full amount again. Unfortunately, the Canada Revenue Agency (CRA) ignores intra-year withdrawals and considers only total contributions to the TFSA in a single tax year. If the total contributions in a single tax year, ignoring all withdrawals, is greater than that eligible contribution amount then penalties may be levied. To avoid all of this always ensure that you make total contributions up to, but not more than, what is your eligible TFSA contribution room on your prior year’s tax return summary. If you are planning a TFSA withdrawal in early 2022, a trick is to consider withdrawing those funds by December 31, 2023. This way, you will not have to wait until 2023 to re-contribute that amount.
5. Make RESP contributions and maximize your 20% grants
RESPs continue to be excellent vehicles. For example, individuals can save for the post-secondary tuition expenses of minor beneficiaries while reducing their tax return. The federal government provides a Canada Education Savings Grant (CESG) equal to 20% of the first $2,500 of annual RESP contributions per child or $500 annually. Unused CESG room is carried forward to the year the beneficiary turns 17. There are a couple of situations in which it may be beneficial to make a RESP contribution by December 31.
Each beneficiary who has unused CESG carry-forward room can receive up to $1,000 of CESGs annually, with a $7,200 lifetime limit, up to and including the year in which the beneficiary turns 17. If enhanced catch-up contributions of $5,000 (i.e., $2,500 x 2) are made for just over seven years, a maximum total of $7,200 can be obtained from Canada Education Savings Grants. In the event that you have less than seven years before your child or grandchild turns 17 and have not maximized RESP contributions, consider contributing by December 31, 2022.
Also, if your child or grandchild turned 15 this year and has never been a beneficiary of an RESP, no CESG can be claimed in future years unless at least $2,000 is contributed to an RESP by the end of the year. Consider making your contribution by December 31, 2022 to receive the current year’s CESG and create CESG eligibility for 2023.
What happens to an RESP if not used?
Maximizing these grants through RESP contributions goes a long way towards covering future education costs, costs which tend to rise at a faster rate than the generalized inflation rate in Canada (The High Price of Higher Learning, Globe and Mail, Nov 8, 2019). Moreover, in the event that your child, grandchild, and any other siblings do not attend post-secondary education, the rules require that grant amounts be paid back. Amounts you contributed are returned to you without being taxed, while gains on contributions/grant/bond amounts, or “accumulated income,” are taxed at your regular income tax level plus an additional 20 percent.
6. Ensure distributions for incorporated business owners do not fall afoul of new income splitting rules
Major changes to the taxation of private corporations were enacted in 2018 and continue to impact business owners in 2023.
On Jan 1, 2018, the tax on split income (TOSI) rules, otherwise referred to as the “kiddie tax” rules, were expanded. The rules were designed to eliminate the income tax benefits of income splitting in situations where the recipient of the income, typically a related family member such as grandparents, parents, children etc. has not made a significant enough contribution to the business to warrant the income.
Here, we detail some of these changes and suggest some steps you may wish to take for your incorporated small business by December 31, 2023.
Get qualified tax advice prior to paying out dividends.
A best practice is to review the share structure of any private corporations with legal and tax advisors prior to any payout allocations. If multiple shareholders own the same class of shares, corporate law may require that you pay the same value of dividends to all shareholders of that class. Professional firms related to law, medicine or engineering related practices should be particularly mindful.
Ensure family members can prove involvement/ownership in the business.
Ensure family members receiving dividends can prove involvement/ownership in the business. Individuals receiving dividends and/or distributions should be able to demonstrate active involvement in the day-to-day operations of the corporation. Various guidelines exist to prove this. An individual should hold a significant amount of equity, at least 10% of the value in the corporation or be able to show regular involvement in decision making, for example, an active email address prior to receiving dividends. This guideline will also generally be met if the shareholder works an average of 20 hours per week in the business. Receiving a regular salary is preferred to recorded timesheets in this application.
Retirement distributions between shareholders and spouses are excluded.
TOSI rules are not intended to interfere with these types of distributions.
Re-examine any estate freezes completed prior to the new rules.
New TOSI rules will likely affect anyone who has done an estate freeze prior to 2018. The TOSI rules would subject dividends paid on most shares received on an estate freeze to the highest marginal tax rate. However, gains realized on the disposition of these shares may be exempt from the rules if the lifetime capital gains exemption could be used to shelter such gains, this figure was $971,190 in 2023.
7. Passive Investment Income
The tax rate on business income earned in a corporation is generally much lower than the top personal marginal tax rate for an individual who earns business income. Until income is withdrawn from a corporation as a dividend, there is an inherent “tax deferral” in the form of reducing personal taxes in favor of paying the lower corporate tax rate. The benefits of deferral for active business income can be quite significant – ranging from 32% to 42% in 2022, depending on the province or territory.
For active business income (ABI) that is not eligible for the Small Business Deduction (SBD), the 2022 tax deferral ranges from 17.5% to 26.7%. The rules pertaining to active or passive income are really about ensuring that these benefits apply only for operational businesses and are not repurposed to benefit passive investors who may be investing via holding companies and would otherwise be facing higher personal marginal tax rates. Some helpful strategies to consider are listed below:
- Consider paying yourself a salary sufficient to maximize RRSPs and TFSAs. Where contribution room exists, vehicles to shelter pre-tax and after-tax income are generally recommended. Moving funds from the corporate side to the personal side can reduce the overall tax burden in these situations.
- Consult with a tax advisor if you are not sure what qualifies as active or passive income. We recommend that you consult a tax advisor prior to finalizing year-end financials. This will determine how provincial and federal measures may apply in your unique case.
- Consider a “buy and hold” strategy to defer gains if nearing the $50,000 AAII threshold in 2020. Consider whether an Individual Pension Plan or corporate funded life insurance plan may be appropriate if AAII exceeds $50,000. Income earned within these plans will not be treated as an adjusted aggregate investment income (AAII).