This article appears in the February 2022 issue of Advisor’s Edge magazine. Subscribe to the print edition, read the digital edition or read the articles online.
Two years of constant change have left many clients’ financial situations in flux. As tax season approaches, here are three areas to review with your clients.
Know clients’ marginal and effective tax rates
With our graduated income tax system, many Canadians pay tax at different rates. As income increases, so too does the tax rate that applies. The marginal tax rate applies to the last dollar of income earned. An Ontario client with total income of $93,000 and no deductions in 2021, for example, would have a marginal tax rate of 33.89% (income over $90,287 up to $93,655).
One’s effective tax rate is the average of the various tax rates paid on taxable income. It’s calculated by dividing taxes payable by taxable income. The effective tax rate is lower than the marginal tax rate, but two people with the same total income can have different effective tax rates.
Take our Ontario client. With $93,000 of total income and no deductions, their marginal tax rate is 33.89%. If we assume all income is employment income and they claim the basic personal amount and Canada employment credit amount, their effective tax rate is 21.92%. Their neighbour is in the same situation but made a $10,000 RRSP contribution. The marginal tax rate drops to 31.48%, but their effective tax rate is 20.7%.
Why does this matter? First, tax deductions such as RRSP contributions reduce taxable income. This can lower one’s marginal tax rate if the RRSP deduction is large enough to reduce income to the next tax bracket. Deductions can also reduce one’s effective tax rates. Second, tax credits, such as those for charitable donations, can reduce taxes payable and lower one’s effective tax rate. While taxes alone should not drive financial planning decisions, knowing your client’s marginal and effective tax rates can help optimize tax savings while addressing their financial priorities.
Know clients’ RRSP and TFSA contribution limits
Has your client been sitting on cash due to the uncertainty of the pandemic? Could that cash be invested toward retirement or other medium- or long-term goals? Is it time to rebalance a taxable portfolio and realize capital gains? Re-allocating funds to registered accounts could be an effective way to achieve several objectives.
Consider a client who realizes capital gains (net of capital losses) of $20,000. The taxable capital gain is $10,000. They have $30,000 of unused RRSP room. They could contribute $10,000 to their RRSP to offset the taxable capital gain (and continue to invest within their RRSP on a tax-deferred basis). This is one way to re-align portfolios or take a profit without an immediate tax consequence if capital losses are in short supply.
If the client has TFSA room, the non-taxable portion of the capital gain could be invested there, protecting it from income tax on any future investment income or realized capital gains.
Review your beneficiary designations
Outdated beneficiary designations could lead to estate distributions that don’t align with a client’s intentions. Discovering this after death limits the options for corrections. Reaffirming beneficiary designations with clients either at the beginning of each year or before each RRSP deadline could lead to a fruitful discussion about the client’s estate plan. Did they recently update their will? Did they get a power of attorney, or change their power of attorney?
There are too many stories about unintended asset distributions that lead to litigation and tension between survivors. Given the experience of the past couple of years, clients are likely to be more open to these discussions.
The first quarter of the year is always a good time to revisit the basics with clients. If they made changes to adapt to the circumstances of the pandemic, now is the time to evaluate if and how they can get back on track with their long-term plans. However, if these changes are permanent, then revisiting and adjusting that long-term plan is in order.
Curtis Davis, FCSI, RRC, CFP, senior consultant for tax, retirement and estate planning services, retail markets at Manulife Investment Management