The Old Age Security benefit is the cornerstone of the Canadian government’s retirement income program. Worth up to $540.12 in the first quarter of 2012, it is available to Canadians 65 years of age and older, so long as they’ve lived in Canada for at least 10 years after the age of 18.Its sister program, Canada Pension Plan, on the other hand, is a contributory program. Those who haven’t contributed to it – those who’ve never earned a salary in Canada and made CPP payments – are not eligible for the CPP benefit.
But there’s a downside to the OAS. Not only does the benefit have to be reported as taxable income, but it’s also subject to a clawback when a recipient’s income reaches a certain threshold. In 2011, the benefit is clawed back at an annual income of $67,668 and disappears completely at $109,607. For 2012, those numbers will change to $69,562 to $112,772 respectively.
“Say your client has $75,000 in annual net income [in 2011]. That would trigger a clawback of $91.60 a month, which would reduce the monthly benefit to $435.25 from $526.85,” said Carol Bezaire, vice president, tax and estate planning, at Mackenzie Financial Corp. in Toronto.
This doesn’t seem fair, she added. Your clients have worked hard over the course of their careers, yet government may be grabbing back their promised pensions. “The OAS is a benefit seniors deserve,” she said. “With the clawback, the government is saying, ‘We’re helping the lowest-income taxpayers."
The OAS clawback is definitely a concern for those entitled to receive it, echoed Aurele Courcelles, director of tax and estate planning at Investors Group in Winnipeg. “It’s equal to 15% of the excess of your net income over the $67,668 threshold,” he said. “It amounts to an increase in your client’s effective tax rate. It’s as if he’s paying more tax, giving the government back money it paid him.”
The tax deduction that can be claimed will help lower the client’s marginal tax rate. But even so, the clawback will result in an increase in the client’s marginal tax rate of roughly 8%-9%, based on province of residence, Mr. Courcelles said. “Here in Manitoba, if the client has $67,668 in net income [in 2011], he’s already paying about 40 cents on the dollar, so he’ll be adding another 8%-9% onto this for income over the OAS income threshold.”
But with careful planning it is possible to reduce or even eliminate the clawback.
The clawback is based on the amount of net income reported on line 234 of the Canadian income tax return. This is net income before adjustments, and any credits or deductions that are reported after that line will not reduce the clawback so any corrective measures will have to focus on the lines that precede line 234.
One of the preceding lines that is of particular note is line 120 that reports taxable dividends from taxable Canadian corporations. “Dividend income is considered tax efficient because it enjoys a much lower tax rate than interest income and, at some levels, capital gains income,” Ms. Bezaire said. “The problem with dividend income is reported dividend income includes a gross-up to approximate the before-tax income of the corporation.”
“The problem,” Ms. Bezaire said, “is that the dividend tax credit comes after net income reported on line 234.”
It might be advantageous to restructure portfolios of clients who are above the OAS income threshold and replace dividend income with income that is not grossed up, but is still tax friendly. “Most seniors tend to gravitate to the safety of guaranteed income certificates and bonds,” Ms. Bezaire noted, “but interest income is 100% taxable. Look for opportunities for capital gains income from conservative investments.”
Divide, defer, deduct
Mr. Courcelles said he likes to follow the three cardinal rules of tax planning – divide, defer, and deduct – to reduce net income reported on line 234.
Divide. Dividing income between married spouses or common-law partners is a classic way of reducing net income. “Take advantage of pension income-splitting rules, which allow a spouse to split up to 50% of income from a pension plan, registered retirement income fund or life income fund,” Mr. Courcelles said. “You’re trying to equalize your incomes as much as possible. Of course, if both spouses earn incomes above the threshold for the OAS clawback, this strategy won’t help.”
CPP and Quebec Pension Plan benefits can also be split, Ms. Bezaire added. “Spouses can also split dividend income by signing it over to a low-income spouse.”
Defer. To defer taxable income, he recommends T-series mutual funds (the T stands for their tax-planning advantages), which have a return-of-capital feature. They distribute monthly cash payments, all or a significant portion of which are classified as tax-free payments of the original investment; when the investment is ultimately redeemed, any realized gain will then be subject to tax. “T-series cash flows are tax-friendly and don’t impact the OAS clawback,” Mr. Courcelles said.
Registered retirement savings plan income can also be deferred, although assets in registered plans must eventually be converted into income. RRSPS must be converted to RRIFs no later than the year in which the client turns 71, and mandatory minimum withdrawals start the following year.
Deduct. “Does your client have any other deductions he can make?” Mr. Courcelles asked. “Make sure he hasn’t forgotten safety deposit boxes fees and your investment management fees.”
Tax free savings accounts (TFSAs) are another, often overlooked, way to produce non-taxable income, Ms. Bezaire noted. As each person may contribute $5,000 to a TFSA each year, and contribution room can be carried forward if it is unused. TFSAs came into effect for the 2009 tax year, so a couple that has never made any contributions could put away up to $40,000 in 2012. Once inside the TFSA, earnings accumulate tax free, and amounts withdrawn are not subject to taxes. “TFSAs are also good places to hold investments that produce dividend income if this type of investment is preferred.” says Ms. Bezaire
Borrowing to invest can also help reduce or eliminate the OAS clawback because interest on the loan is tax deductible.
Some clients might consider distributing some of the assets that would be part of their estates during their lifetimes in order to reduce their net worth. “But this won’t work in all families,” Ms. Bezaire said. “It would be a pretty drastic move just to escape the tax man.”
The strategies above will also work to reduce or eliminate clawbacks to other benefits that seniors are entitled to.
The federal age credit of $6,534 in 2011 is available to Canadian taxpayers age 65 and over, and clawbacks to it start at $35,961. “The credit is reduced by 15% for every dollar of  income above this threshold,” Ms. Bezaire said. The 2011 tax credit vanishes at an annual income of $76,541.
Provincial age credits, Mr. Courcelles added, vary from province to province and are clawed back at different thresholds. “In Manitoba [for 2011] it is $3,728 and it is $4,254 in British Columbia,” he said. “The provincial age credit is also clawed back at 15%. In Manitoba, the  clawback starts at $27,749 and disappears at $52,602.”
The guaranteed income supplement is a monthly benefit paid to OAS recipients with little or no additional income. The maximum monthly GIS benefit for the first quarter of 2012 is $732.36, and the annual income threshold for 2012 is $16,368 “Over this, the GIS is clawed back at 50% or 50 cents on every dollar,” notes Ms. Bezaire. “But for couples, if one spouse qualifies, it is only clawed back by 25% or 25 cents on every dollar.”