Taxes are among the biggest expenses for high net-worth (HNW) business owners and their families, so strategies that minimize tax exposure are key.
“High net-worth families know they can’t control the market, so they are focusing on what they can control – their taxes, which are their single largest expense,” says Tony Maiorino, vice president and head of wealth management services at RBC Wealth Management, a division of Royal Bank of Canada, in Toronto.
“What is notable about high net-worth Canadians,” adds Maiorino, “is that they see wealth as a family affair. And one of their top concerns is making sure their wealth is passed on to and preserved for future generations.” Sheltering taxes can play a significant role in achieving this goal, he says. “For high net-worth individuals in particular, [saving taxes] can mean a large dollar amount.”
The strategies that are the most useful for these purposes usually are complex. Among the most common are individual pension plans (IPPs), retirement compensation arrangements (RCAs), specialized insurance strategies, and charitable giving and foundation planning.
Here’s a look at IPPs and RCAs:
– IPPs can be used by affluent business owners with incorporated firms to shelter a greater portion of income from taxes than could be sheltered with RRSPs, says Henry Korenblum, tax manager with Kestenberg Rabinowicz Partners LLP in Markham, Ont. IPPs work best for corporate executives or professionals earning $100,000 or more in annual employment income and who are 40 years of age and older. IPPs can take the place of RRSPs, but greatly reduce the amount that can be contributed to an RRSP.
An IPP is a defined-benefit pension plan that is structured for a single individual, who must receive T4 income from their personal corporation that is eligible for pension benefits. Other types of income, such as self-employed income and dividends, are not eligible. Contributions to the IPP, which are set by actuarial formulas based on the taxpayer’s age and income, are made by the corporation.
IPP contributions have the disadvantage of being locked in and cannot be accessed before retirement, unlike RRSPs, which can be liquidated at any time. However, the amounts that can be contributed to IPPs are significantly higher, with the amounts rising as the taxpayer ages.
An IPP provides an annual pension equal to 2% of the taxpayer’s employment income, up to certain income maximums. In 2014, the maximum income was $138,500, or $2,770 in pension income. In 2015, the maximum income was $140,945, or $2,818 in pension income.
Among other advantages, the personal corporation may deduct the contributions from corporate income, and the amounts in the IPP are immune from the claims of creditors – a key consideration if your HNW client anticipates financial troubles in the years ahead. Investment-management fees charged to the IPP also are deductible by the corporation.
On the other hand, there are costs associated with annual federal and provincial reporting, as well as an IPP’s creation and ongoing management. The personal corporation is required to make pre-set contributions, even in years when it is less profitable.
– An RCA, says Maiorino, is not an extension of an IPP, but has similar benefits. RCAs are used by companies to provide supplementary retirement benefits to high-income employees. For example, executives and sports professionals use RCAs to “put away large sums of cash for some potential future use,” says Maiorino.
But RCAs are not as simple and flexible as IPPs and should not be viewed in isolation from other investment and income sources. Contributions to an RCA are made by the employee’s company to a third party (the custodian) to fund benefits paid to the employee after retirement.
When the employee’s company makes a contribution, 50% is deposited with the custodian to be held in an investment account and the other 50% is deposited with the Canada Revenue Agency (CRA) as a refundable tax credit in a non-interest- bearing account. Half of all interest income, dividends and realized capital gains earned in the investment account must be remitted to the account held with the CRA.
“As the employee receives benefits, the CRA refunds $1 from the refundable tax account for every $2 paid out by the custodian,” says Maiorino. “RCA payments can be received as lump-sum payments or as supplementary retirement benefits.”
While an RCA is less flexible than an IPP, there are no costly actuarial valuation requirements for an RCA. In addition, a tax deduction for the RCA contributions is immediately available to the contributing corporation, while the employee does not pay taxes on contributions to the RCA until benefits from the RCA are received.
Another plus is that the taxes ultimately paid on RCA funds may be lower than they would have been when the money was earned. This is because the employee’s income may decline in retirement. On the downside, the amounts that must be held in the refundable tax account are high, leaving less available for active investing.
In the April issue: Specialized insurance strategies; charitable giving; and foundation planning.
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