The Smith Manoeuvre and the TFSA - a Primer
The 1990’s and 2000’s saw a lot of interest in the “Smith Manoeuvre”, I’ve seen books, online calculators and websites dedicated to the concept. Interest and usage has dropped in recent years due to a few factors, one of the biggest being the introduction of the Tax Free Saving Account (TFSA).
What is the Smith Manoeuvre?
First let’s back up and look at the basic premise of what we are talking about: leveraged investing. Leveraged investing involves borrowing money to make an investment. If the chosen investment meets CRA’s criteria, the interest that is paid on the borrowed money can be used as a deductible on your income tax return.
The Smith Manoeuvre sometimes takes this concept one step further by utilizing investments that you may already have. Using the Smith Manoeuvre, you could sell those investments and use the proceeds to pay down debt that does not allow interest deductibility (usually a mortgage on your principal residence). The next step involves borrowing the money (a secured line of credit is often used) and making a new investment with the proceeds. Provided that you follow the rules that Canada Revenue Agency have in place, the interest on the newly borrowed funds may be a tax deduction. You could continue to pay down the mortgage (interest of which is not deductible) and borrow more funds (interest is deductible) to make extra investments. The goal of this is to make all of the interest on your debt tax deductible, thereby “Making your mortgage payments tax deductible”. Depending on each person’s situation, this concept could be accomplished in as little as 1 year or used over a number of years.
Sample Smith Manoeuvre Scenario:
Karen has a home worth $400,000 and a mortgage of $300,000. Her mortgage payments equal $1,600/month. Karen has an RRSP portfolio with $100,000 invested as well as an investment portfolio with stocks and mutual funds worth $125,000.
Karen decides that she wants to utilize her existing assets to give her the ability to make some of her interest tax deductible. Karen can liquidate the holdings in her investment portfolio and pay her mortgage down by $125,000. If she then re-borrows the $125,000, she can invest the funds. If Karen follows the CRA guidelines she would be able to make a portion of her interest tax deductible. This may be a great tool to use in the right situation.
Can Karen Use the $100,000 RRSP Portfolio Too?
No, interest borrowed to invest in a registered account (RRSP, RESP, or TFSA) is not deductible.
|Karen’s Situation Before||Karen’s situation after|
|Annual Deductible Interest:||$0||$4,167|
Basically nothing has changed in Karen’s overall financial picture but she has achieved her goal of making a portion of her interest tax deductible. Karen can use the growth of her investments to pay down her mortgage and borrow more of the equity each year, and she could eventually move all of the interest to the type that is tax-deductible.
Why Isn't the Smith Manoeuvre More Popular Today?
That is a quick explanation of how the Smith Manoeuvre works. So the question is…why are fewer people using this strategy? One reason may be low interest rates. Interest rates have been at historic lows for quite a few years, many people just haven’t had the desire to go through the process of rearranging their financial affairs to take advantage of this strategy because the value of the tax deductions has gone down.
Another major reason is the introduction of the Tax-Free Savings account (TFSA). Prior to the TFSA being ready, Canadians could have investments inside their RRSP or outside. If the investments were inside the RRSP, the taxes are deferred but there is no interest deductibility. There is also a limit of how much can you can deposit into a registered account and the type of investments that are allowed. Many Canadians have non-registered investment accounts as well as RRSP’s.
The TFSA introduced a third option which Canadians have embraced - these accounts are a great tool to eliminate taxes completely on investment assets. While the amount of funds that can be deposited into a TFSA is relatively small, the TFSA is a great wealth building tool. Unlike the RRSP, we do not get a tax deduction for funds that are invested in the TFSA, the TFSA is funded with after tax money. The real power of the TFSA is that it offers tax free growth, unlike the RRSP which only offers Tax-Deferred Growth. Any funds that are withdrawn from an RRSP are abundantly taxed (exceptions being the lifelong learning plan and first-time homebuyers plan). In the TFSA however, funds that are withdrawn are never taxed.
If you are thinking about using the Smith Manoeuvre, you need to weigh these 2 options:
- Interest Deductibility
- Fully taxable investment Growth
- Investment losses can offset capital gains taxes in the future
- No interest deductibility
- Tax Free Investment Growth
- No ability to utilize capital losses
Other Factors to Keep in Mind:
Your personal TFSA Limit – in 2018 your limit is $5,500 and you can use up the limit from previous years if you have never contributed (up to $57,500 if you were eligible for each year). Keep in mind that this is per person, if you have a partner or spouse you can utilize the limit for each.
- Your marginal tax rate – This validity of this strategy will vary depending on your personal income tax situation.
- Liquidity requirement – How much of the invested funds will you need to access and when?
- Interest rates – the higher the interest rates, the advantage you can get from interest deductibility.
- Risk tolerance – If you have a low risk tolerance this strategy may not work
- Income splitting – If you have a partner or spouse with a lower income, you can use a spousal loan in conjunction with the Smith Manoeuvre to split income and potentially lower your overall tax bill.
- What specific investments are you planning to invest in?
- Is the investment available for holding in your TFSA?
- Does if qualify for interest deductibility?
- How is it taxed? Interest, dividends and Capital Gains are all taxed differently in a Non-Registered account.
Consult a professional. A Certified Financial Planner can help you determine if this strategy is right for you.