At this point in the Smith Manoeuvre strategy we will dive into the tax considerations. Tax advantages are a key component of the full SM strategy.
A distinct advantage of the SM over simply paying your mortgage and investing on the side is saving piles of money on taxes year after year--which, naturally, is put back to into investments. These tax savings will grow with compounding returns, helping you achieve financial independence.
Step 11: Claiming Investment Income
T5 - Statement of Investment Income
As you will recall from Step 7, the investments purchased in your Smith Manoeuvre Cash/Margin investment account have to produce some income to be eligible for Interest & Carrying cost deductions on your income tax return.
While interest and foreign dividends are acceptable, for maximum tax efficiency we will normally focus on investments in Canadian dividend-paying companies.
Every year in January or February, your brokerage will provide you with a T5 - Statement of Investment Income for the prior year. This tax slip is similar in many ways to the T4 your employer provides you.
The T5 slip will specify the different forms of income you realized in your investment account during the year. This includes Canadian eligible dividends, other Canadian dividends, capital gains, foreign income, and interest income.
How to Claim in Tax Returns
If you're in a solid relationship, you should normally use joint accounts for investing. However, as per the CRA, the tax liabilities are based on how individual(s) actually contribute to that joint account. It does not have to be equally split between nameholders on the account.
In most normal circumstances, for tax purposes, the lower income partner will claim contributions and income on Cash/Margin accounts. That's because the higher earning partner would pay the household bills and contribute to registered accounts. The lower income partner just invests in their TFSA and taxable investment accounts. Blog post with details on that here.
The Smith Manoeuvre is different. All income and expenses will be claimed by the higher income partner. If both partners are in the same tax bracket, earn a similar amount, and this is expected to continue in the future, split the income and expenses evenly between partners.
This means the income will be claimed 100% by the higher earning partner, or 50/50 between equal earning partners. You will choose how you will allocate Smith Manoeuvre income and expenses before you start the strategy and you will stick to that exact allocation forever. If you change the allocations down the road because your income situation changes you will get into trouble and you could pay penalties, back taxes, and more.
When completing your tax return, whether you do it yourself, hire the mall kiosk lady, or pay a proper CPA, just make sure you let them know what you are doing and do not be persuaded to change allocations down the road for any reason.
Tax programs, whether you file as a married couple or not, will allow you to separate your investment income how you desire because in Canada you are always taxed as an individual.
Simply plug the numbers from the T5 slip boxes into the tax program under the correct individual and it will automatically apply the correct tax situation. Because you are realizing investment income as part of the Smith Manoeuvre, you will be paying taxes on that income. Read up on Step 7 again to design your investment income appropriate to your earning situation.
Don't worry too much about incurring a moderate tax bill here though; investment income is almost always tax advantageous compared to earned income.
In Step 12 we will be adjusting the interest expenses by the RoC amount.