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Dale Jackson

Personal Finance Columnist, Payback Time

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If you are one of the millions of Canadians patting themselves on the back for meeting the March 1 registered retirement savings plan (RRSP) contribution deadline: congratulations. 

You will likely be rewarded with a cash refund after the May 2 deadline to file your income tax. 

But before you book that vacation getaway, there’s a compelling case for using it as a down payment on a long-term tax strategy that could generate thousands of dollars through what tax experts term “tax-free compounding.” In other words, tax savings can be used to generate further tax savings, which can continue to compound in investments over time.   

Unlike most investment strategies, an effective tax strategy generates risk-free returns by utilizing and co-ordinating the tax tools available to average Canadians. 

A qualified tax professional can provide a tailor-made strategy for your specific financial circumstances. Here are some basic steps to get started.


REINVEST RRSP REFUND

The RRSP is a great retirement savings tool because contributions can be deducted from your income. The biggest savings come to those with big incomes who would normally be taxed at a high marginal rate. As an example; if your top rate is forty per cent, your refund will be about forty per cent of your contribution.

Reinvesting your refund in your RRSP will not only add to the total amount compounding in investments over time, but will also generate further refunds. Using the example already mentioned, each refund would be forty per cent of the previous reinvestment.


CHANNEL CONTRIBUTIONS TO TFSA

Ottawa limits how much you can contribute to your RRSP; but, from a tax perspective, it is possible to contribute too much even below that limit. Unfortunately, contributions and all the returns they generate over the years are fully taxed according to the going marginal tax rates when they are withdrawn. 

You could be the victim of your own success - and even have some of your Old Age Security (OAS) benefits clawed back - if your annual RRSP withdrawals are taxed at a higher rate than the original contribution.

That’s when you need to look into your crystal ball and determine how much of your savings and RRSP refunds should be channeled into your tax-free savings account. 

Unlike RRSP contributions, TFSA contributions can not be deducted from income but they - along with any investment returns they generate - are not taxed when they are withdrawn. The only exception are dividends from U.S. equities.

You can adjust the balance between your RRSP and TFSA according to each year’s income and over time as your retirement goals become clearer, but the ideal tax situation would be to draw income from your RRSP at a low marginal rate and top up any additional income from your TFSA.

TAX PERKS

There are ways to incorporate investments in non-registered accounts into your tax strategy.

The biggest tax advantage outside of a TFSA or RRSP is the 50 per cent capital gains exemption, which only taxes half of the gains on stocks or other equity investments when they are sold. 

While a 50 per cent capital gains exemption is not as good as a 100 per cent exemption in a TFSA, investors in non-registered accounts can also benefit from market losses. Tax-loss selling permits the use of equity losses to recoup capital gains taxes already paid in the past three years or apply them against future capital gains.  

Dividend tax credits are also granted on eligible equities in non-registered trading accounts.


MAKE YOUR TAX BURDEN A FAMILY AFFAIR

Investors can also keep more of their tax dollars invested by splitting income with a lower-income spouse, who is taxed at a lower marginal rate. 

Higher-income spouses can split up to half of their income with a lower-income spouse once they turn 65, but there are ways to transfer the tax burden beforehand through a spousal RRSP. The higher-income spouse can deduct contributions from their income (at a high marginal rate), and withdrawals are taxed in the hands of the lower-income spouse (at a low marginal rate).