When considering The Smith Manoeuvre, it is very important to have a good understanding of the rules around mortgages, investing and taxation. After all, we are taking action to improve the financial life of our family and we don’t want to make any assumptions on anything and mess up the advantages the strategy brings us.
The Canada Revenue Agency (CRA) has strict guidelines when it comes to…well, everything…but also when a Canadian can or cannot deduct interest on money which has been borrowed. There is a simple test which will lead you in the right direction – what did you do with the money you borrowed?
If a Canadian borrows to consume – that is, to buy items such as vehicles, food, clothing, gas, furniture, vacations, our homes, etc., then the interest on the borrowed funds is not tax-deductible. This is because it does not pass the test. In order to be tax-deductible, the money must be borrowed to invest with the reasonable expectation of generating income. When we buy these consumption items, we are borrowing to consume, not to generate income. To be clear (and there are often exceptions), when you buy your car, you are not generating income with it, when you buy food you are not generating income, when you buy your house with borrowed funds, you are not generating income – you live in it.
When can one deduct the interest? When one borrows to invest in stocks, bonds, mutual funds, ETFs, MICs, REITs, investment real estate, their own business, someone else’s business…there is a wide universe of investments which qualify for deductible interest.
So, we know that over here we have items we for certain cannot deduct interest on and over there we have investments we certainly can deduct interest on, but what about the middle of the sandwich – registered investments? It would appear that investments held within registered accounts, such as a TFSA, have the possibility of generating what we may call interest. After all, if I own a dividend stock within my TFSA, it still earns dividend income; if I own bonds within my TFSA, these bonds still earn interest income. That being said, we cannot deduct the interest on money borrowed to contribute to our registered program such as RRSPs and TFSAs. But why is that?
Income inside registered investments don’t meet another important piece of the puzzle – sure, we are earning income inside our TFSA or RRSP, but it grows tax-free. The CRA does not tax our earning within registered investments. And in addition to that nice little nugget, in the case of RRSPs they have already given us a tax deduction on the initial contribution; and for TFSA’s, they do not tax us when we withdraw our earning from the account. So the CRA is being kind to us in that they are giving us tax advantages when we contribute to, grow in, and withdraw from our registered assets, but they will only go so far in the kindness department. And in any event, it may be too much for us to ask for tax-deductibility on top of the other tax advantages the CRA is giving us anyways.
So in order for The Smith Manoeuvre to function, we are required to invest in non-registered, or ‘open’, accounts if we want to claim the tax deductions which provide us Canadians much needed tax relief. That being said, if you ask any good tax professional, they will explain to you why it is tax-beneficial to not only have registered investment but also have non-registered investments. Also, just because you have not maxed out your registered accounts does not mean you are not ready to implement The Smith Manoeuvre. Remember, the dollars we contribute to our registered investments come from our after-tax dollars, but the dollars we invest from our Smith Manoeuvre is brand new money – money we freed up simply by changing how we flow our existing dollars.
So go on contributing to your registered assets with your after-tax dollars, but implement The Smith Manoeuvre and free up hundreds, if not thousands, of dollars each month to invest even more into a non-registered account – if you were already contributing $300 per month to your registered investments, after starting your Smith Manoeuvre, you now have even more to invest. And more is better.