Nine Common Tax Mistakes We See On Tax Returns

With tax season behind us, we thought it would be a great time to get you planning for next year. It's nice to learn from your own mistakes, but even better to learn from other investors' mistakes!

9. Not harvesting losses before the end of the year:

Long-term, we know that stocks can go up, but as we observed in 2020, they can drop significantly in the short term. Tax-loss harvesting is a great way to make lemonade out of your portfolio's lemons. Here's how it works; let's say you invested $10,000 in Exxon mobile in Sept 2019 at $70/share in a non-registered account; the low point in 2020 your $10K would have dropped to is $4,700. To harvest this loss, you would sell Exxon and crystallize a $5,300 loss. If you have a non-registered portfolio with a mutual fund or ETFs, you likely received some capital gains distributions. You can use the loss to cancel out part of these gains, carry the loss back to use against gains from one of your three previous returns, or carry it forward indefinitelyⁱ. For the sake of this example, let's assume you had a capital gain of $5,300 in your non-registered account, and you're in the highest marginal tax bracket (53.53%) ⁱⁱ.The tax savings available for crystalizing this loss are ~$2,800. Tax-loss harvesting opportunities won't always be available to you, but not taking the opportunity could add up to hundreds of thousands in lost tax savings in your life. We should note that you must wait 30 days before repurchasing the share, or superficial loss rulesⁱⁱⁱ will deny you of claiming the loss. Instead, the denied loss is added to your cost base on the repurchased shares. One way around this is to buy a stock or fund to stay invested in something with similar potential for growth.

8. Donating cash instead of appreciated stock:

Suppose you regularly make significant charitable contributions and have a non-registered investment portfolio with stocks that have gained a lot in value over the years. In that case, you can realize considerable long-term tax savings by donating shares In-Kind and using your cash to repurchase the shares. Another obvious situation to donate shares resulting from a demutualized insurance policy. Many Canadian investors hold Sunlife shares through a trust company like AST. The cost base of these Sunlife shares is zero. We know you may want to keep the shares because you like receiving quarterly dividend cheques; however, if you planned a $5 K charitable contribution and have $5 K of Sunlife shares, you could donate the shares In-Kind. You could then repurchase the stock with the cash you would have otherwise donated. In doing so, you'll receive a tax credit of ~$2 K and avoid capital gain tax. Your new shares will also have a cost base of $5 K, meaning if/when you decide to sell them, your capital gain tax will be $2,500 lower.

7. Not using your RRSP strategically:

We have heard people say things like "RRSPs are great!" or "I don't like RRSPs". The reality is that RRSPs can be an excellent tool for some investors and less beneficial for others. RRSPs are ideal for someone in the highest tax bracket (income over $220 K) with no pension and a spouse with low or no income. The key to maximizing the benefit of the RRSP is to put money in when you're in a high tax bracket and take money out when you're at your lowest tax bracket. If you are approaching retirement, have a high income, no pension, and room in your RRSP, you should go to almost any length to contribute to your RRSP; yes, that includes borrowing!* We have seen scenarios where an individual is in the top tax bracket, plans to retire next year (2022), won't have other income in their first year of retirement, and has over $100 K of RRSP room. This investor could borrow $100 K using a home equity line of credit to invest in their RRSP in the first 60 days of the following year. They would receive a refund of ~$46 K (assuming they are earning $220 K or more) and withdraw another $60 K from the RRSP the same year. Even if the $60 K withdrawal pushed their income to $100 K, they would still realize massive tax savings. The strategy above is what wecall tax arbitrage, and the person who executes this strategy will save (make) over $25 K in tax. There are several other strategies to use RRSPs more effectively. We'll cover those in future posts, so stay tuned!

6. Not deducting your investment fees:

The fees charged in your non-registered accounts at Assante are tax-deductible. We send you a tax report to tell you precisely what you can deduct. You can copy and paste this line directly onto the carrying charges section of your tax software (line 22100) or give this report to your accountant. Like an RRSP contribution, your deductible fees lower your earned income dollar for dollar. As an example: If you're in the 40% tax bracket and your fees are $6 K, the difference between deductible fees and non-deductible is $2,400 of tax savings to you. It always amazes me how people will spend time at the grocery store comparing orange juice based on volume vs. price but won't take the time to see if their fees are deductible. You would have to get many deals on orange juice to get to the savings you're missing by not deducting your non-registered account fees!

5. Not deducting student loan interest:

If you have kids in post-secondary school, you know how expensive it can be. If your kids have student loans, they can deduct the interest on these loans. OSAP is interest-free until graduation, but once interest kicks in, be sure to log in to the lender's portal, where they will provide a statement of interest paid. A friend of mine realized he had been missing out on this for the last four years. When he went back to refile those returns, not only did the refund cover the accountant's fees, it put an additional $700 in his pocket!

4. Starting CPP or OAS at the wrong time:

Some of the mistakes we see affect your taxes indirectly, and taking CPP and OAS at the wrong time is one of these. We wrote a blog post about deciding when to take CPP. OAS can be clawed back once your income reaches $79,845 and is fully clawed back at 128,149*. If you are under age 70 and your earned income is $128,149, there is $0 benefit to receiving OAS. Once your income exceeds $79,845, your tax rate combined with OAS clawback in Ontario is 46.48%. Similarly, you'll receive 7.2% less CPP for taking it before age 65 and an increase of 8.4% for every year you delay it after 65, but unlike OAS, that reduction/increase persists annually. The decision to take CPP at age 64 instead of 66 could cost a retiree $67,590 over the next 30 years, and that doesn't include the opportunity cost of the accumulating difference.

3. Not using the pension income tax credit:

A pension income tax credit of 15% of a taxpayer's first $2,000 of pension income is available for any taxpayer over age 65. iv Some provinces also have a pension income credit. If you have a pension, your tax software will automatically calculate this credit, but if you do not have pension income, you can create this credit for yourself by converting your RRSP to a RRIF at age 65 and withdrawing $2,000 from it. For low-income seniors over 65, this $2,000 will often be taxfree after accounting for the credit, and in some situations, it may even create an additional refund of $300. The pension income credit is one of the only situations where the government will essentially pay you to withdraw money from your accounts. They are much more familiar with charging you to do so!

2. Not planning around OAS Clawbacks:

Combining points 9, 8, 6, 4 above (and point 1 below) can help you avoid clawbacks. We don't want to overlook the fact that if you're having OAS clawed back, you have a relatively high retirement income compared to the average Canadian. Sometimes OAS clawback is unavoidable, but if you're able to use any of the other strategies outlined here to lower your taxable income, you can realize significant tax savings. Going from $90 K to $80 K, for example, you will save ~$4,600 on taxes and clawbacks, and if you can lower your income from $128 K to $118 K, you'll save ~$5,800 in tax. This amount of savings in one year is significant, but when you multiply it by 25-30 years and apply a rate of return to that amount, the numbers get large.

1. Not splitting Income with your spouse:

Income splitting during retirement is the easiest way to lower your family's collective tax bill. It’s as easy as checking a box on your tax return. Here's an example of the hidden cost of not checking that box. Take a couple where one spouse works and has a pension. The other stayed home to raise the children. The working spouse retires at 60 with a pension. Combining his pension and CPP, his income is $70 K. The stay-at-home spouse has $0 income. In Ontario, $70 K of regular income results in tax payable of $13,587. But since a couple can split pension income starting at age 60, the working spouse can essentially move part of his pension income over to the stay-at-home spouse's tax return. There are slightly different rules for splitting or sharing CPP, but there are ways of equalizing CPP income as well, which we will leave for a future article. For the sake of the example, let's assume this couple can split the $70 K 50/50. The combined tax of spouses earning $35 K each is $8,795 or a tax savings of $4,793 compared to the "no income splitting" scenario. If you apply a rate of 4% to this tax savings and compound it over 25 years of retirement, the total is $207,500!

Conclusion

I know, bargaining to get a $3,000 deal on a new car is much more exciting than knowing you saved $3,000 by splitting income with your spouse and much easier to understand. Still, the reality is that the savings possible from effective tax planning tend to be much more repeatable and, in many cases, lead to more significant savings than a one-off discount. For most taxpayers, tax planning amounts to scrambling every February to make a first 60-day contribution to RRSP. A better approach is to engage in tax planning at the beginning of each year.

* Using borrowed money to finance the purchase of securities involves greater risk than using cash resources only. If you borrow money to purchase securities, your responsibility to repay the loan and pay interest as required by its terms remains the same even if the value of the securities purchased declines. A homeowner who withdraws equity from their home to purchase securities should fully understand this risk.