Suddenly Everything Changed
David Christianson, BA, CFP, R.F.P., TEP
“Dollars and Sense”
Winnipeg Free Press
November 24, 2006
The Minister of Finance pulled the rug out from under many of the basics of financial planning with his news conference on Tuesday night.
Along with the introduction of taxes on income trusts, were some fundamental changes to the strategy of income splitting through financial planning. Equalizing retirement income between spouses decreases the family tax bill and helps prevent clawbacks of OAS and other income–tested credits. Planning involves basics like spousal RRSPs and having the lower income spouse save his or her income, and range to sophisticated techniques like inter-spousal loans at the CRA’s prescribed rate.
Income splitting is especially valuable if one spouse has a large pension or substantial capital, and the other spouse has little or none. Equalizing the incomes at retirement saves a significant amount of tax, compared to one spouse paying tax at the top rate and the other spouse paying tax at a low rate.
As an example, Dale, 66, has a $60,000 pension, plus OAS and CPP, for total income of $75,842. Kim has OAS and 30% of the CPP maximum, for a total of $8,950 taxable. Kim pays no tax, while Dale pays $22,440, including OAS repayment of $2,255.
If their pensions were split equally, family tax is reduced to $17,775, and no OAS clawback, for a total saving of $4,665.
Now Finance Minister Flaherty has announced that pension incomes can be split starting in 2007 (something we lobbied for in this column two months ago), and the Manitoba government has agreed to follow suit. We don’t know yet if this will reduce OAS
clawback; they could do it either way.
The criterion is that the income be eligible for the pension income tax credit. From age 65 on, virtually any type of regular income from a registered account is eligible, such as periodic income from a RRIF, LIF or LRIF, in addition to company pensions and annuities.
For married and single seniors, the pension credit was increased in the May Budget from the first $1,000 of pension income to now $2,000 of pension income.
New this week is the increase in the age credit amount from $4,066 of income to $5,066 of income, effective in the current (2006) tax year. The credit effectively eliminates the tax for low and middle-income seniors on that $5,066 of income. This credit is fully phased out when net income reaches $64,043, up this week from the previous $57,377.
This increased credit will save low and middle-income seniors about $150 per year of federal tax, decreasing as income rises above $30,270 of net income.
If you own income trusts or mutual funds that invest in trusts, you might notice you have a lower account value than you did on Tuesday. That’s part of the bad news. The
reason is that Mr. Flaherty decided to stop the migration of companies from a corporation structure to the tax-free income trust structure by announcing that income trusts will be taxable like corporations in 2011. In return, the distributions will then attract the dividend tax credit, reducing the tax that taxable investors pay now on their distributions.
The reason that is not good news is that lots of trusts are held by RRSPs, RRIFs and pension plans, where the distributions are not taxed. If you hold your trust in a taxable account, then the tax changes should mean that you end up with the same after-tax cash flow as you had before the changes. However, since you will be receiving less total cash up front, you will be penalized by the timing difference from when you receive your cash until you pay your taxes.
The good news is that that your trusts are still paying out the same income today as Monday, and the new tax won’t be implemented for four years. Essentially, you now
own a corporation with a four-year tax holiday.
Under the new rules, the trust will pay corporate tax before being able to pay out the distribution, and therefore can’t give you as much money. However, you will pay less tax
on the income you receive, ending up in the same boat as today.
It’s a totally different situation if you hold your trust inside an RRSP or RRIF, since those are tax-sheltered accounts, and you didn’t care what tax rate was applied to your distribution. All you cared about was the maximum number of dollars coming to you, and these dollars will now be decreased.
It’s quite possible that these changes are good tax policy and will stop the conversion of corporate Canada to income trusts. Foreign investors are also penalized significantly by the decreased cash flows, as they only paid a fixed 15% tax on their
distributions. However, it is also possible that the lower valuations will allow many Canadian business entities to be gobbled up by foreign investors.
We shall see.
David Christianson is a fee-only financial planner and investment counsel with Wellington West Total Wealth Management Inc. His column appears Fridays. You can e-mail him at firstname.lastname@example.org