The Smith Manoeuvre: Step 11

Step 11: Claim the Investment Income on Your Tax Return

Tax advantages are a key advantage of the full Smith Manoeuvre strategy. While you will pay some tax on your investment income, you will get to claim back large tax deductions year after year. These tax savings are put back into your investment portfolio so they can compound over time.

T5 - Statement of Investment Income

The investments purchased in your Smith Manoeuvre investment account have to produce some CRA-approved 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 you will normally invest 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 of an account are actually based on how individual(s) contribute to that joint account. It does not have to be equally split between name-holders 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. 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 investment income will be claimed 100% by the higher earning partner, or split 50/50 between similar earning partners. You must choose how you will allocate Smith Manoeuvre income and expenses before you start the strategy and you will need to stick with that exact allocation for the duration of the Smith Manoeuvre.

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. They might not know, or even understand, what you are doing.

Tax programs—whether you link files as a married couple or not—will allow you to enter your investment income how you desire. Unlike the U.S., 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 owing for your situation. You will always be realizing some investment income as part of the Smith Manoeuvre, so you will be paying taxes annually 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 almost always carries lower tax rates than earned income.

Friendly Warning: If you change the allocations down the road because your income situation changes, you can get into trouble and you could pay penalties, back taxes, and more. See a professional accountant for help if your incomes change substantially and you need to adjust the strategy.

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