Wealthy people have a peculiar problem. Yes, they pay a boatload of taxes, but that alone is not the issue. Much of the income of many high net worth investors is taxed at the highest marginal rate. With top marginal rates approaching 50% on interest and other income for most Canadians, this tax bite seriously erodes investment returns. Take a bond yielding 4%, for example. At a 50% tax rate, the after-tax return is only 2%.

That is just the tip of the iceberg. This calculation fails to consider inflation. Net of 2% inflation, the real, after-tax return is nil. Zero, zilch, nada, nothing! By taxing both the real and inflationary component of investment returns at high marginal rates, the government eviscerates the compensation due high net worth investors from bonds and GIC’s.

The situation is a little better for equity investments. Only one-half the realized gain is included in taxable income. However, given today’s unexciting valuations, the expected capital gain on equities is around 6% annually. With taxes chewing up 25% of this gain and inflation at 2%, the after-tax, after inflation return is 2.5%. Add in the after-tax return from dividends, modestly tax-advantaged in the case of eligible Canadian dividends, and the after-tax, real return from stocks is in the 4% range.

It is these disheartening numbers that motivate savvy high net worth investors to defer taxes. This isn’t merely postponing taxes. By deferring taxes, an investor is effectively receiving an interest-free loan from the government and, to the extent investment income is earned on this loan, wealth can be enhanced.

Take the example of $1-million growing at 6% per annum on pre-tax basis. If the 6% gain is realized every year and a 25% tax paid, the after-tax wealth grows to $1.55-million over 10 years. If the tax is deferred and only paid at the end of the 10th year, the after-tax wealth accumulates to $1.59-million. The $40,000 difference is the return earned on the deferred taxes.

These numbers skyrocket for longer periods. Over 30 years, based on the same assumptions, the investor who pays tax every year ends up with $3.75-million. The investor who defers taxes and pays them only in the 30th year has $4.56 million, a difference of over $0.8 million. Time is Archimedes’ lever in deferral strategies.

The traditional deferral haven is RRSPs. The drawback of RRSPs is that they end up fully taxable on withdrawal or after conversion to a RRIF or annuity. TFSAs provide deferral for the entire life of the holder and their spouse or common-law partner if they are named as the “successor holder” and withdrawals are not taxable. Unfortunately, this perfect solution is marred by the paltry contribution limits. Nevertheless, both play a role in a family’s deferral strategies as do RESPs.

One of the most powerful deferral tools is minimizing the sale of stocks in a portfolio. For a married or common-law couple, the taxes on unrealized gains can be deferred until the death of the second partner creating a multi-decade opportunity for wealth enhancement. ETFs tracking broad market indexes are an unparalleled vehicle for combining tax deferral with diversification and low management fees.

Whole life and universal insurance policies are additional deferral vehicles since they are not subject to taxation on their accumulating reserves if they meet the “exemption test” set out in the tax regulations. For business owners and professionals, the small business deduction, a reduction in tax that is available to Canadian-controlled private corporations on active business income, allows for the accumulation of capital taxed at a much lower rate.

The key to investment success isn’t just “buy and hold” — it is “buy, hold and defer”.

-Michael Nairne, CFP, RFP, CFA, is the president and chief investment officer of Tacita Capital Inc., a private family-office and investment counselling firm in Toronto.

If you’re a wealthy U.S. citizen or a wealthy Canadian who owns property in the United States or holds significant U.S. equities in your stock portfolio, you may want to be extra wary of who’s pouring your eggnog at Friday’s New Year’s Eve party.

That’s because in less than 24 hours, the dreaded U.S. estate tax will resurrect itself from the grave. In other words, die before midnight tonight, no U.S. estate tax. Die on January 1, 2011 or later and your heirs may face an estate tax of 35%.

U.S. estate tax affects both U.S. citizens living in Canada as well as non-U.S. citizens who own U.S. situs property such as U.S. real estate or stocks in U.S. companies, even when held in Canadian brokerage accounts or registered plans.

The estate tax repeal was originally announced back in 2001 as part of a broader tax reform package, which lowered the top tax rate on estates to 45% from 55% and increased the exemption to a high of US$3.5-million in 2009.

When President Bush introduced the estate tax phase out and elimination legislation in 2001, it had a sunset clause in it meant to circumvent a U.S. Senate rule that could have allowed Senators to block the legislation if it increased the federal deficit beyond a ten-year term – resulting in an legislative expiry date of December 31, 2010.

As a result, if nothing was done, then in 2011, the estate tax would come back in full force with a top rate of 55% and an exemption of only $1 million.

An infamous 2001 column by syndicated New York Times columnist Paul Krugman referred to the legislation as the “Throw Momma From the Train Act of 2001” predicting what might happen to wealthy American matriarchs in 2010 whose heirs might benefit by an opportunistically-timed death in the family.

At least five known billionaires have died in the U.S. in 2010 escaping the estate tax altogether: Dan Duncan (estimated net worth US$9-billion), John Kluge ($6.5-billion), Mary Janet Cargill ($1.7-billion), Walter Shorenstein ($1.1-billion) and, perhaps most famously, Yankees owner George Steinbrenner with a mere $1.1-billion.

Earlier this month, however, the uncertainly ended when new legislation was signed into law on December 17, officially reinstating the U.S. estate tax beginning in 2011, at a rate of 35% and with a US$5 million exemption.

Canadians who aren’t U.S. citizens can’t use the full exemption but must use a prorated exemption under the Canada-U.S. tax treaty which allows Canadian residents to prorate the US$5-million exemption based on the fraction of their U.S. situs property (e.g. U.S. stocks or real estate) divided by their worldwide estate.

Mathematically, this means that if your worldwide estate is under US$5-million you will get a full exemption from U.S. estate tax and need not be concerned.

Wealthy Canadians with a net worth of over US$5-million, however, may wish to get specialized tax advice in 2011 – that is if they survive tonight’s party.

Jamie.Golombek@cibc.com

Jamie Golombek, CA, CPA, CFP, CLU, TEP is the Managing Director, Tax & Estate Planning with CIBC Private Wealth Management in Toronto.