Gimme Shelter

All of us wish to be immune from tax, but few of us are. If you want to protect your income from tax you will need a strategy that considers time, risk and a few other variables. Then you can go to the buffet of methods.

All of the material here is meant to be for discussion. Ideas shown here are pure forms. Others exist that hybridize the types. Not everyone should participate in any particular type. They should fit together with other plans and should achieve known purposes. You will be best served if you discuss the material with professional advisers familiar with both the concepts and your personal situation.

The idea of a tax shelter is that you can invest or reinvest money that would otherwise have gone to the government. It could be current tax due or it could be tax on future income from the investment. The amount of tax deferred is a good measure of the value of a given kind of shelter.

Income tax shelters are based upon two premises:

  1. I can deduct my investment
  2. I can defer tax on the income my investment earns

This leads to four possible formats.

Type 0 I cannot deduct the capital and I cannot defer the income.

Type 1 I can deduct the capital and I cannot defer the income it earns

Type 2 I cannot deduct the capital and I can defer the income it earns

Type 3 I Can deduct the capital and I can defer the income

Type 0 are probably best avoided. They are included here for completeness. They include things like bonds, GICs, mortgages, and the like. You should hold these investments inside some other format or hold them for reasons that are more valuable than the adverse tax treatment. They have no tax shelter value.

Type 1 shelters are common in November and December and are used by people who are tax averse and who can bring other factors to the investment party. Things like risk tolerance, ability to accept ambiguity, investment skill, liquidity, and patience.

These shelters have an interesting defining characteristic. Their value is greatest at the beginning. They tend to wear out quickly after that. Once the initial investment has been deducted, the ongoing income will add to income. Eventually you will need more shelters to protect the income the early ones are generating.

As one pro hockey player pointed out, “You don’t have tax trouble until your shelters are making money.”

They tend to be best when the client wants to move income a year or two into the future. Maybe just before retirement. More commonly they are sold to people who value reduced tax payments more than increased net worth.

Type 2 shelters provide no immediate relief because you can’t deduct the investment. They provide shelter for future income not for current income. As opposed to Type 1 shelters their tax value is lowest in the beginning and increases over time.

There may be tax due some other day, but not always. If you buy a Picasso, you may have a large gain someday, but until you sell it, it appreciates without tax. More likely than a Picasso, most of us will have a TFSA. It will grow forever with no current tax and no tax at surrender either. There are limits on how much you can invest but not on how much capital you can accumulate. A TFSA is close to being a given for everyone. An ideal home for bonds and GICs. Sadly, only for smallish amounts of investment.

Life insurance is interesting too. If properly designed, the investment income grows tax deferred. If you withdraw capital, some or all may be taxable. If you leave it there until death, the accumulated income becomes tax free. There are limits on how much you can put in per thousand of insurance

In all Type 2 shelters, their greatest value is far in the future.

Type 3 shelters are theoretically most desirable. They include RRSPs, pension plans and the like. The theoretical part comes into play when you realize that all are created by specific legislation and all have limits on the capital deposited. More serious all have rules to force the amounts back onto your future tax returns. If you don’t get around to spending all the money, your estate will pay the tax on what remains.

All type 3 shelters are useful but they need to strategically managed. For example maximizing your RRSP up to age 72 and then taking minimum RRIF payments will be unlikely to create the most wealth for you. The beauty of deferred income and deductible capital may be a trap once you are near retirement. You can work it out for you own case.

In type 3 shelters the peak value of tax deferred occurs a few years after retirement and eventually falls to zero.

Tax shelters are more complicated than most people think and they don’t work for everyone. They should be considered in any case where people are taxed currently at high rates and have capital to invest or who have growing investment income.

It is okay to say no to tax shelters as long as you can say no for a reason. Usually the reason is it
does not make any real money

Don Shaughnessy is a retired partner in an international accounting firm and is presently with The Protectors Group, a large personal insurance, employee benefits and investment agency in Peterborough Ontario.

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