It's always a great idea to use simple strategies to save money on income tax wherever you see an opportunity. Tax savings is one of the easiest ways to increase your net worth without taking on additional risk.
In Canada our combined tax rates (federal income, provincial income, municipal property, sales tax, and excise taxes) are very significant. A typical Canadian household with two working adults will pay a total tax rate around 40% of their gross income. An individual earning over $220,000 a year in Ontario can easily be paying total taxes in excess of 60% of their income. While $220,000 a year is certainly a solid income, it’s not extreme by any means. That’s just four times the average salary and well below the salary required to be in the top 1% of income earners.
Within the confines of the law, you should take all reasonable steps to reduce your tax bill so that you can improve your personal well-being. This means the simple steps like contributing to your TFSA and RRSP accounts, investing with tax efficiency in mind, and taking deductions for things like charitable contributions and child care expenses. However, restructuring your assets and debt using a Debt Swap can be very lucrative as well.
Performing a Debt Swap means using income-generating assets to pay off debt related to non-productive assets and using debt to buy income-generating assets instead. One example of this is the Smith Manoeuvre, but it’s not the only way.
On this blog I’ve talked a lot about the Smith Manoeuvre. It’s a great strategy to put a portion of your home equity to work for you in a productive way while still keeping debt to a responsible level. However, full implementation of the Smith Manoeuvre isn’t for everyone. It takes a lot of a work to keep the strategy active.
Paying Down Your Mortgage with Your Non-registered Investments
You don’t need to do a full Smith Manoeuvre to save a lot of money on tax. You can simply use your non-registered investments to pay down your mortgage in a lump-sum one time and borrow the money back to invest. This is called a Debt Swap and it can save you thousands of dollars in tax each year.
The Smith Manoeuvre requires you to max your HELOC loan with every mortgage payment, moving money across several accounts every few weeks. By performing a Debt Swap, you can do this simple trick just once, or every few years as you see fit.
This simple move is exactly what accountants and financial planners for the wealthy perform to save rich people thousands of dollars every year in tax. It's perfectly legal and it's a simple, smart way to save money.
Mr. & Mrs. Grey live in Quebec and have a $400,000 home with a $250,000 mortgage balance. Aside from their investments in registered accounts (TFSA and RRSP), they have $100,000 in their non-registered investment account. That money is invested in a stock ETF paying a 2% dividend with a cost-basis of $80,000. They currently earn an equal income of $60,000 a year each and no longer have any dependents at home.
Under current circumstances, they will pay a total tax bill of $28,651 per year. This leaves them a net income of $93,349 for spending and savings.
Now we’ll examine what happens when they perform a simple Debt Swap. They sell their $100,000 in non-registered investments to pay down their mortgage. The mortgage balance (bad debt) is reduced to $150,000 and they will borrow back $100,000 in a HELOC at the current rate of 3.95% to repurchase a similar investment in their non-registered account (good debt). Their tax bill on the capital gain of $20,000 from selling their investments will be a one-time cost of $3,710. For simplicity sake, we'll assume they pay this cost from their regular income so they can still re-invest the full $100,000.
They will still have $250,000 in total debt, their $400,000 house, and $100,000 invested in their non-registered investment account. However, now $100,000 of their $250,000 debt is tax-deductible. They will deduct $3,950 per year in interest costs at tax time.
This simple move allowed them to reduce their tax bill to $27,185 per year—saving them $1,465 per year in taxes. That’s a 5.1% drop in total annual taxes. The tax savings from this move will pay back the $3,710 tax bill from the original sale of investments in less than three years. Following this, every tax dollar saved goes straight to their net worth.
If the Grey’s invest the $1,465 tax savings in an investment account, it will grow to $55,000 over twenty years. That’s a lot of money gained from tax savings for doing a little Debt Swap!
Good Debt vs. Bad Debt
The foundation for this advantage is in changing the composition of your debt. Wherever you can find the opportunity, you should swap bad debt for good debt. Nearly always the tax savings will quickly pay for any costs associated with the change and you’ll be better off over the long term.
The only good debt is debt where you can deduct the interest costs from your income every year to save money on tax. This means good debt must be loans used solely to purchase productive, income-generating assets. That includes most ETFs, dividend paying stocks, bonds, preferred shares, and rental real estate. Generally higher income individuals should avoid investments that distribute a lot of income. It’s important to recognize that the income from the investment does not necessarily need to match or exceed the interest costs at any given moment; however, the investment must have a reasonable expectation of profit over time.
If good debt is any loan where the interest is tax deductible, bad debt is precisely the opposite. Any loans you have where the interest cannot be deducted from your income for tax purposes is debt that should be avoided. This includes your house mortgage, personal loans for consumer expenses, vehicle loans, credit card debt, payday loans, and loans used to purchase an investment that does not generate some form of eligible income (dividends, interest, rent, or other business income). Always avoid using loans to purchase an investment that only provides Return of Capital Income or distributes Capital Gains Income (common in REITs, Series T mutual funds, and swap-based ETFs).
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