HOW TO BEAT THE BUDGET BY BECOMING LOW-INCOME FOR TAX PURPOSES
In 2016 if you are high income, you will be paying a lot of tax. I mean a LOT of tax.
Based on the current tax rules and budget, below is a strategy that would add $ 760,000 in future wealth to our fictional family. While every situation is different, you might benefit from this new thinking.
In Ontario, the marginal tax rate for income above $ 220,000 is 53.5 per cent. Add HST, real estate tax, extra taxes on gasoline, alcohol, etc. and some people are now paying well over 50 per cent of their income in taxes.
To help uncover some ideas to mitigate this tax burden, I asked my partner at TriDelta, Asher Tward, to analyze a couple of strategies to determine the longterm impact of the changes.
We will use a fictional family of five for the scenario: husband, 50 and a dentist; wife, 47 and an office manager; and three children, ages nine, 11 and 13. They live in Toronto in a house valued at $ 2 million, with a $ 300,000 mortgage. They have set up a professional corporation and, after expenses, they could potentially dividend out as much as $300,000 a year if needed.
Previously, this couple could determine their annual expenses, decide on the right level of income and whatever was left over remained invested within the corporation. Living in Toronto with three children, they found that their expenses were $ 180,000 a year ( including RRSP contributions).
What they had been doing was taking about $ 220,000 in combined salaries. They did this rather than take dividends, as they found it to be a virtual wash from a combined tax perspective ( company and personal taxes) and liked being able to save in their RRSPs. In total, this allowed them to save some funds in the corporation each year as well. With t heir i ncome, t his family will receive $ 0 under the Canada Child Benefit, introduced in the 2016 federal budget.
Of interest, if the family’s income were $ 30,000, then their CCB would be $16,200, tax-free.
In addition, they would probably see another $1,000 to $2,000 in benefits around GST credits, Ontario property tax credits, Ontario health premium and medical expenses. Let’s say their extra benefits from this low income are $ 17,700 for the year, tax- free. This is on top of having a very low tax rate. That could be a huge benefit for this family.
The only problem is that this family doesn’t make $ 30,000 in family income, they make about $ 220,000. So, how do t hey make $ 30,000 and, even if they make $ 30,000 in taxable income, how do they fund their $180,000 lifestyle?
A new for 2016 strategy for this family is as follows:
1. Pay themselves a combined income of $ 30,000, using dividends from the company.
2. Put a home equity line of credit in place on their home. Since it has $ 1.7 million of real estate equity, and their income has been strong, they can likely get a $ 1 million line of credit priced at Prime + 0.5 per cent, which today is 3.2 per cent.
3. After their $ 30,000 draw and $ 17,700 of tax benefits, they will still need to draw over $ 100,000 from other sources to fund their lifestyle. They would defer RRSP contributions. Year one they would borrow the funds from the corporation at one-per-cent interest.
4. In year two, they would do it all again, but this time they would need to borrow from their line of credit to pay back the corporation, and to fund year two expenses. They now have a line of credit loan of $ 218,000. Fortunately the 3.2- per- cent interest rate is much lower than any tax rates, and the i nterest costs are easily covered by a portion of the extra tax benefits. Interest rates could rise on the line of credit, but look stable for a while. We have assumed 3.5 per cent as an average interest rate.
5. They would continue this process for five years, but in year six, their eldest child turns 18. The bad news is that the child will no longer qualify for the CCB; the good news is that she can now be paid a dividend by the corporation. As a university student with little income, she can receive maybe $40,000 in dividends with a low single- digit tax rate. This child can gift these funds to her parents to pay down their line of credit.
6. The net result in year si x is t hat t he parents’ family income remains the same, but instead of needi ng to borrow another $ 100,000- plus, they need to borrow only $65,000-plus.
7. In year eight, the second child turns 18. Family income remains the same, but with the same scenario as before, new borrowing is now less than $30,000.
8. In year 10, everything changes. There are no children under 18. All three children receive dividends from the company, and the company pays out $320,000 in total dividends to the parents and children. They no longer care about family income for CCB, as there are no more eligible children. The line of credit balance was up to $ 730,000 ( total debt was still under 40 per cent of house value). We assume the kids receive dividends from age 18 to 23.
9. Depending on interest rates on the line of credit, comfort level with risk and tax rates, the parents can now choose to aggressively pay down the line of credit or to let the balance sit there.
There are a lot of moving parts, both personally and in the corporation. We tried to do an apples- toapples comparison of two different strategies, and we found that if we went to year 35 ( ages 84 and 81 for the parents), they would be $ 760,000 ahead after tax by using the low income and line of credit strategy than they would be if they continued to draw their current salary.
If we assume a two- percent i nflation rate, t his would equate to roughly $ 380,000 of benefit in today’s dollars — maybe not life changing for this couple, but certainly enough to make the strategy make sense.
We recognize that every situation is quite different, and only those with a corporation may have the flexibility to choose their annual income. However, given that a decent percentage of highincome earners are business owners and/or have a professional corporation, we believe this approach may have real merit for some families.
IN YEAR 10, EVERYTHING CHANGES. THERE ARE NO CHILDREN UNDER 18. ALL THREE CHILDREN RECEIVE DIVIDENDS FROM THE COMPANY, AND THE COMPANY PAYS OUT $320,000 IN TOTAL DIVIDENDS TO THE PARENTS AND CHILDREN. — TED RECHTSHAFFEN, TRIDELTA FINANCIAL