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Pillars of Tax-Efficient Investing: Income Deferral

income deferralWith income tax season just around the corner, now is a perfect time to review your portfolio of investments to ensure you’re minimizing the income tax it triggers.

In creating a tax-optimized plan, keep in mind the 3 key pillars of tax-efficient investing:

  1. Income Deferral
  2. Income Splitting
  3. Income Conversion

In the first of a three-part series, we look at income deferral.

Income Deferral

The benefits of income deferral as a tax planning technique are two-fold:

  1. Your marginal tax rate may be lower in the future
  2. Deferring tax effectively discounts your final tax bill

Much of our retirement plan, such as the use of registered retirement savings plans (RRSPs), is based on this premise.

Your investments grow tax-free in your RRSP during your higher income working years. Then, when you retire and start withdrawing income that is taxable from your RRSP, your income from all sources likely will be lower and you will be in a lower tax bracket.

The benefits of income deferral also apply to short-term income deferrals, such as shifting a tax liability from one tax year to the next.

This strategy could be as simple as holding off selling those stocks that have accrued sizeable capital gains until a later year when you think your income will be lower.

You could also defer claiming a RRSP contribution until next year if you think you’ll be in a higher tax bracket and would receive a higher refund.

Benefits also arrive from longer-term income deferrals, which you can achieve by buying tax-sheltered investments such as flow-through shares.

If you invest in the flow-through shares of Canadian companies that explore for minerals, oil or gas, you receive a substantial write-off of the purchase price, with deductions for the remaining purchase price over the following 2 or 3 years.

In this case your share cost would be deemed to be nil for tax purposes. For certain types of flow-through investments the federal and provincial governments also provide additional tax credits.

In dark times when your stock portfolio takes a hit, tax loss selling might be the only bright spot.

With tax loss selling, you may be able to salvage something, and possibly even get a refund of taxes paid in previous years, if you actually sold some of your securities at a loss.

You can apply those capital losses to offset capital gains to prior, current, or future tax years. 

Read part 2, the second pillar of investing – Income Splitting.