Transcript | Tax planning

Sarah Widmeyer:  Welcome to Conversations on Wealth, hosted by Richardson Wealth, a podcast dedicated to helping Canadians with your total financial picture.

Our approach is unique. We examine wealth through a multi-dimensional lens in order to offer you integrated strategies to grow and preserve the legacy you have built. 

I’m Sarah Widmeyer, Director of Wealth Strategies at Richardson Wealth. And joining me today is Sean Hsu, a Senior Tax Specialist at Richardson Wealth. Thank you so much for being here today.

Sean HsuI'm happy to be here.

Sarah Widmeyer: So tax season. Two very exciting words.

Sean Hsu: Put together, yes. You're asking that, you're telling this to the wrong person.

Sarah Widmeyer: When it comes to implementing tax strategies into a wealth plan, no two individuals or families or businesses are alike. I'm guessing it's so important to stay in tune with your tax strategies because as life evolves, so will the options you have at your disposal. Sean, why should we care about tax management as part of a holistic wealth plan?

Sean Hsu: Yeah. So so it's a very great question that you pose. And it's very timely that we're approaching tax season that we're talking about this. But really, tax planning and effective tax planning should be ongoing. It's not just limited to March and April, when you have to file your returns. And it's not limited to just the month of December, where you usually see a sporadic rise of people doing last minute planning. And the reason why it's important to think about taxes because simply put, it's a cost of wealth at all stages. So it's a cost when you create wealth. If you're a salaried employee, you see and you feel the hit of income taxes, being withheld from your paycheck every two weeks or whatever the schedule is.
It's also a cost me deplete wealth, especially in retirement, when you've worked so hard to build the wealth that you've created, and your nest egg and you start using it to enjoy your life, hopefully, you need to think about taxes. And lastly, it can be quite a significant cost when you're transferring your wealth both during your lifetime and especially upon death. Which is why we see a lot of the most complex tax planning focused around the area of wealth transfer. So really, it's important for wealth creators, users and transferers, if that's a word, to look for opportunities to strategically manage our taxes. And we need to be proactive about this. Because as with anything else, any kind of planning, it works best from a tax perspective when you think about it logically beforehand and you have the time to implement it rather than being reactive?

Sarah Widmeyer: Yeah. So it really is an active thing. And I think that's probably one of the most important things that you just said. Because I must admit, I think about taxes maybe twice a year. And Yep, you pretty much nailed me. November, December and when I'm filing. So it really is something that needs to be actively managed, planned for, revisited, and really thought about more than twice a year.

Sean Hsu: Yeah. Because over time, it can create a huge depletion of your wealth if you don't manage it properly. Little things that you miss here and there add up over time.

Sarah Widmeyer: Yeah, they sure do. So what are the main categories then of tax strategies?

Sean Hsu: You mentioned a very well at the beginning that tax planning and tax strategies are so unique to every individual. And that's what keeps tax fun for accountants like me. But fundamentally speaking, I think we can kind of strip down tax planning to three foundational concepts. And I call them the three Ds of tax planning.
So the first D is the Deduct. So as the term suggests, that the deduct strategy relies on you being able to either claim deductions against the amount of income that's subject to income tax, or reduce your tax by claiming credits. So an example of a deduction is using realized capital losses that you have on your investment and offsetting that against the capital gains each year. An example of a credit is donation tax credit, so when you donate to a registered charity, the charity will issue a slip, which then calculates $1 for dollar credit that can reduce your tax liability when you file your tax return. So that's the first strategy.
The second D is the defer strategy. And so this strategy relies on the fact that here in Canada, we pay income taxes at graduated marginal rates. And what that means is as we earn more income in a year and exceeds certain brackets, each additional dollar of income then gets taxed at a higher and higher rate. So if you can defer the recognition of an item of income from a year where you're at a high marginal rate to a future year when hopefully you're at a lower marginal tax rate, then over time you achieve tax savings. How do you do that? So there's there's many strategies. The easiest example I can think of is the Registered Retirement Savings Plan - the RRSP. You can contribute money to the RRSP and while it's in this plan. All the income, the gains that are realized within the plan are tax deferred, you don't pay taxes on them on an annual basis. You only pay income tax when you start taking money out. So ideally, you keep that nest of funds in there, let it grow on a tax deferred basis. And in the future when you're hopefully in a lower marginal tax rate, you take that money out, and you pay less tax.
The third D, the last main category of strategy is the divide strategy, or what we commonly hear of as income splitting. So, this strategy goes back to the other reality of our tax system, which is that every individual here in Canada files their own tax return. So unlike the US, Canada doesn't have a system of a joint filing where married couple or common law partners file as a household combine their incomes together on one return and pay taxes together. So if you were to take two couples as an example, where one couple has a spouse that earns $200,000 and the other spouse is not working - so earns no money -  and then you compare that with another couple where each spouse is earning $100,000, that ladder couple ends up paying less Canadian income tax overall than the first couple simply because, again, each individual files their own tax return. And so with less income on each person's returns, you pay less taxes overall. So both couples bringing in $200,000 together, but one couple ends up having more after tax money afterwards.

Sarah Widmeyer: Not getting into too much of the specifics, but if I'm an employee, and I'm making $200,000 as an employee, and my spouse is not working, the income is getting taxed at source. Can I split that income with my unemployed spouse or it's really something I can't take advantage of?

Sean Hsu: Well, you can think employment income, you can't necessarily split.

Sarah Widmeyer: But you can split pension income.

Sean Hsu: You can split things like pension income, or even what you do with that in net after tax employment income that you have sitting in an account. You can use more sophisticated strategies to potentially shift the future income off that pool of capital to a spouse that may not be earning their own income and would have a lower marginal tax rate.

Sarah Widmeyer: Okay, so what I'm hearing in again, speaking in generality, I'm not too many specifics. There are opportunities for tax planning and tax strategies, even if you are employed and employee getting tax pulled off at source. There are some things that you may be able to do in order to reduce your tax even if it's in a deferred way. 

Sean Hsu: Yes, absolutely. And you'll see the most sophisticated tax planning around this divide strategy. So oftentimes, you'll see more complex structure setup like a family trust, or a holding company to deal, to allow you to potentially split some of that income from any capital that you've accumulated to your other family members who aren't necessarily paying the same rate of tax that you are.
So, we talked about the three strategies, but it's important to, I think, to emphasize that these three strategies are not mutually exclusive. You can actually combine some of these strategies together. So one example that I think relies on all three strategies is the idea of doing a spousal RRSP. So, where you have the higher income spouse contribute to a spousal RRSP where the annuitant of this plan is the lower income spouse, the high income spouse who contributes the money gets a tax deduction for the contribution, going back to the deduct strategy. Then as we talked about earlier, the funds and the RRSP grow on a tax deferred basis, so that the defer strategy, and then when the lower income spouse being the annuitant takes that money out in the future, in most cases that withdrawals taxed at the lower income spouses hands. So then that's the divide strategy. So, you know, tax planning doesn't have to necessarily be so complex, it can be as simple as setting up common things like a spouse, RRSP, and you get, you get to take advantage of all three foundations of tax planning.

Sarah Widmeyer: Okay. So those are proactive examples. Can you talk us through some scenarios, and I guess consequences where proper tax planning hasn't been put in place?

Sean Hsu: Right. So as you mentioned, tax planning needs to be ongoing and proactive because if it's not, you're more likely to miss opportunities to deduct, defer and divide. We are are a self assessment tax system here in Canada, so we file our own tax returns. And then it's up to the Canada Revenue Agency to essentially audit the return and say whether it's right or wrong. So the CRA is not going to be knocking on your door and saying, oh look, you forgot $10,000 of eligible deductions that you could have claimed against your business - wouldn't that be nice, right? Nobody from the CRA is going to do that.

Sarah Widmeyer: There's no CRA fairy.

Sean Hsu: Yeah. So not having the knowledge of the strategies that are available to you at your point in life, exposes yourself to the possibility that you end up paying more taxes than you need to.

Sarah Widmeyer: So it's like, buyer beware, filer beware.

Sean Hsu: Right. And you don't necessarily need to know all of the strategies yourself, you're not expected to be a tax expert, but you want to be able to work with people that can proactively look for these strategies for you. The more troublesome result of improper tax planning that I see arises from a lack of thoroughly understanding the relevant facts, the circumstances and the objectives of the clients. So, for example, sometimes accountants will be very keen on proposing very complex structures for high net worth families involving, again, holding companies, trusts. Presumably, it's done for tax and estate planning purposes. But this type of planning may overlook a client's tolerance for complexity and their understanding of the structure because ultimately, the client is responsible for managing that structure on a go forward basis. And that can be a lot to deal with both administratively and from a cost perspective, and over time that can outweigh the tax benefits that were proposed when the initial structure was set up. So, sometimes I'll ask a client and I'll, we'll see the structure and we'll ask, what's your understanding of it? And so many times clients will say, my accountant told me to do it.
No idea or I'm not sure, but I think it's because. And that's fine, right? You're You're not a tax expert. You're running your business, you're running your career. But you don't want to let others or yourself, let tax be the primary driver of your wealth planning to the detriment of other objectives. Because if you can't manage that complexity, how are you going to expect your family to manage that complexity if your goal is to transfer your wealth to the next generation?

Sarah Widmeyer: They have no idea.

Sean Hsu: Another reason why not understanding the client specific situation can be so dangerous is because you end up omitting key pieces of information which can derail the planning almost instantly. One thing I often see is a planning structure put in place involving a family and nobody knew that one of the family members is a US citizen. Or a US green card holder.

Sarah Widmeyer: Yeah. Or even, I've heard about some some issues with children that are living in Europe. And it's different tax code.

Sean Hsu: Absolutely. So now you have to integrate the US or whatever tax law of this jurisdiction that a family member's in into this existing planning that was Canadian centric. So conventional planning that you see day to day doesn't really work if somebody is international. But if the structure's already in place, these omissions which seem kind of tiny in the grand scheme of things, can cause a detrimental impact on the tax planning. And sometimes it can become very costly to clean up and you end up getting rid of all the financial advantages that you are thinking you would achieve because you're spending so much time and effort and money cleaning it up.

Sarah Widmeyer: So how often Then in this active, proactive tax management that we're now all doing, how often should we be sitting down and reviewing these strategies? Is it, do we wait for a trigger? Or is this something, this is just good maintenance? We should be doing this every so many years.

Sean Hsu: Absolutely. So, ideally, you look at it year to year. So, you don't necessarily need to think about it every month of every year, but especially if something important happens, like somebody is thinking about moving out of Canada or a career change. These trigger points, like you mentioned, especially necessitate the need to look back at your tax strategies that you've implemented. And that's what keeps tax professionals continue to be employed and enjoying their job hopefully, because tax planning is constantly evolving, and it's evolving for two main reasons.
So one reason that's within our control is because life evolves. So, for example, when you're young tax planning can be as simple as contributing to your RRSP, or your tax free savings account every year, if you have the money to do it. Then as you grow up, you may start a family have children. And if you want to support their post secondary education, you may think about contributing to a registered Education Savings Plan, or an RESP, which provides you the ability to invest within the plan, let it grow on a tax deferred basis. And then when the child starts going through post secondary education, and money's taken out from the RESP, to fund that, that income is taxed to the child's hands, so you're dividing the income. 
And then when your retirement like you mentioned earlier, you may start being able to split or divide things like your pension income between spouses to reduce household taxes overall. And then, as I mentioned, more complex tax planning is required at those trigger points. So if somebody is moving outside of Canada, you'll need to think more about tax planning. Or if you decide to invest internationally, you found your dream home in the US, in Florida, you'll need to start thinking about US tax planning. So that's one reason why it's important to look at your tax strategies. It's not just one and done. It's not static, its dynamic. 
The other reason why tax planning needs to be monitored, and this is not within our control, although the government may like to make us feel that it's within our control is because laws change. The perfect example of this is the extensive, what are called the tax on split income, the TOSI rules that were expanded about almost three years ago, that impact private company owners and their families. So just as background you used to be able, as a private company shareholder, to pay dividends from this corporation to other family members who are also shareholders to use the divide strategy, so you pay dividends out to family members that are at a high tax rate, so that overall the household pays lower income taxes. The only main caveat back then was that the recipient had to be at least age 18. Because if that recipient was under 18, then what's called the Kiddie tax would apply where that dividend is then subject to the top rate of tax, regardless of that recipients marginal tax rate. So that was kiddie tax back then. Now with these TOSI rules that have been now in law, those rules essentially extend these kiddie tax rule to all shareholders. So even if you're over the age of 18, even if you're a spouse, if you pay out a dividend to somebody who isn't necessarily involved in the family business to try to split income, those dividends may be subject to top rate taxation, regardless of the individual's on marginal tax rate. So a lot of accountants before had set up structures that work before to deal with the kiddie tax. But now they're forced to revisit every structure that they've put in place to see whether or not income splitting is still possible for a family that has a family business.

Sarah Widmeyer: So how can wealth and financial planning help with tax planning?

Sean Hsu: So a wealth planning exercise helps address some of the issues that we were talking about inefficient or improper tax planning, because it ideally forces clients to think about all the components of their wealth and their purposes for it. It helps generate more thought and conversation on a client's short and long term goals and objectives. And that naturally leads into a review of the tax strategies that could be applicable both now and in the future to help them preserve, create or enhance their wealth. And I see a lot tax can sometimes be the driver that gets clients interested in doing more fulsome wealth planning. You regularly hear clients say, I want to minimize taxes as much as possible. I'm tired of paying the government so much or I feel like I'm paying the government so much, and that's a great way to get your foot in the door. That being said, I think it's important to emphasize that when we're doing a wealth planning exercise at our firm, tax is only one component of effective wealth management. As Sylvia mentioned in a previous podcast episode, tax is what's called a quantitative issue. But in the type of wealth planning that our firm does we also want to look at, and we also actively look at the qualitative issues as well, like what the purpose of your wealth is, and how do you want to use it for yourself or for others? Do you have any concerns about your wealth? These qualitative considerations may sometimes conflict with the quantitative considerations like tax minimization. And so sometimes you have to weigh your options. And sometimes you do have to forego the strategy that could reduce your tax bill because other objectives are more important.
So one example I can think of, is if you set up a trust holding a bunch of investment funds for the benefit of a child, and it generates income every year, that income if you don't pay it out, or make it payable to the child then gets taxed within the trust, and it's taxed at the top tax rates. So that's just the way the rules work. Yeah. Now, from a tax minimization perspective, you can certainly make that income, you can pay that income or make that income payable out to the child. And then that income gets taxed at the child's marginal tax rate. So you can shift that income. So that's a tax minimization strategy. But if your investment portfolio and the trust is millions of dollars, and it's generating income of hundreds of thousands of dollars, do you really want to be paying or making payable that income out to the child every year? Are you worried that that income is going to go into child's hands and they're just not going to be motivated to work or become a trust fund baby. A lot of people are worried about trust fund kids. Or they become a spendthrift. So, even though you can reduce tax by doing this, you may not want to because, overall, it's more important for you to steward that wealth. Start to allow the child to be effective and productive.

Sarah Widmeyer: Yeah, that's a great example.

Sean Hsu: Yeah. So you don't want to let the tax tail wag the wealth planning dog so to speak.

Sarah Widmeyer: There you go. Well done.

Sean Hsu: Yeah. And and one more thing I'll add is the other benefit of wealth planning is that it can help consider some of the existing tax knowledge or ideas that clients have and it and it brings it home - we look at whether it makes sense to them. So clients will often say I've heard of a tax strategy because my friend did it or heard about it in the news. And they feel like they're missing out. But through wealth planning, we can see whether those strategies that they've learned about makes sense in their own particular circumstances. So strategies like loaning money to a spouse to potentially reduce taxes payable on the investment income may not make sense if the clients are constantly spending tons of money every year over time. So we look at things like that. And and it's not necessarily evident unless you go through a wealth planning exercise and you do projections to see what your wealth is going to look like 5 years, 10 years, 20 years down the line. And that really helps guide a better conversation on the tax planning that that's available. And so accountants love it. Yeah, clients like it because they learn more, we educate them, and they can then have a more productive and fruitful conversation with their advisors. They come armed with more knowledge, and knowledge is power.

Sarah Widmeyer: So insurance, I've heard insurance can play an important role in tax planning. Can you talk to me and tell our listeners a little bit about how insurance can do that for us?

Sean Hsu: Sure. So insurance can can be an extremely powerful tool that we consider in the context of wealth planning because, quoting a colleague Jeff Fray, he always says insurance can be a very cost effective, tax efficient way of achieving long term objectives. So a great example of this is when we go through a wealth planning exercise and understand what the client's objectives are, we may learn that they have a cottage that they want to pass on to their children when they pass away. Well, do they understand that when they pass away, the cottage is deemed to be disposed of for tax purposes. And so any appreciation is subject to income tax upon death. Do they know that? Do they have sufficient assets? Now knowing that do they know that they have sufficient assets to help fund that tax liability from other sources and be able to keep that cottage whole to be able to transfer it on to the children? If you don't, then the executor ends up having to sell the cottage to fund the tax liability, and then that completely frustrates the client's objectives.
Another example of this is shares of a family business. If you want to transfer the shares of the family business on to your children, the same issue occurs - there's going to be a big tax bill at death. Do you have enough assets from other sources to pay for that tax? And if not, then something has to be done with that corporation and it's not kept whole. And then the other issue is, what if there are multiple children, and only one wants to cottage or the family business and the other children don't want it? If your goal is to equalize your children, do you have enough in your estate to keep the cottage or the family business whole for the child that wants it, have enough assets elsewhere to pay the tax bill on those assets and still have enough so that every other child has the same amount overall? And so these are important questions that people don't always think about, and don't necessarily tie into insurance planning. So, a way we manage this through the wealth planning exercise and the projections that we prepare through a wealth planning exercise, we can evaluate then whether it makes sense to use life insurance as a solution.
So right now, would you be able to pay for a life insurance policy that would pay out a certain amount when you pass away to pay off the tax bill on the cottage or the family business so that it can be kept whole and there are sufficient funds to equalize the other children? If the math shows that it works, then then we recommend it to our clients or we let them know of the strategy. And clients are often surprised at how insurance can play into that because oftentimes insurance is thought of as an expense or oh god they're trying to sell me insurance.

Sarah Widmeyer: Or I have so many assets I'm so self insured I don't need the insurance. So, they're not thinking about the insurance as buying dollars for pennies.

Sean Hsu: Yes. buying the opportunity to transfer the assets you want, and leave the legacy you want how you want to leave it.

Sarah Widmeyer: Right. Any closing thoughts before we wrap up today?

Sean Hsu: So I think we summarized it very well. Tax planning is dynamic, it's not static. And it changes as life and laws evolve. So it's important to start now. Tax planning is not just for the ultra high net worth, it's for everybody. And so it's important to build long standing relationships with advisors that you can trust that can help you navigate through the landmine of tax law that seems to increase every year, so that you can better create, manage use and transfer your wealth.

Sarah Widmeyer: And it can be super exciting.

Sean Hsu: Exactly.

Sarah Widmeyer: Implementing tax strategies can have multiple purposes. Some of the strategies we talked about today may be relevant to you, but talking to your Advisor or tax professional, or both, is the best place to start to address your specific situation. If you'd like to learn more, please visit our website for articles and videos. And follow us on LinkedIn for the latest on tax strategies that could benefit you over the long term. Conversations on Wealth is available wherever you get your podcasts. Thank you all for listening. Thank you, Sean, and I look forward to our next conversation.

The opinions expressed are the opinions of the author and readers should not assume they reflect the opinions or recommendations of Richardson Wealth Limited or its affiliates. Past performance may not be repeated. Richardson Wealth Limited is a member of Canadian Investor Protection Fund. Richardson Wealth is a trademark of James Richardson & Sons, Limited used under license.