It is common to find people who are struggling to save for retirement. Luckily, there is a powerful way (Smith Manoeuvre) to save for retirement without using your cash flow. Hopefully, this article will help you understand what the Smith Manoeuvre is, including eligibility, how one can set it up, and the risks and benefits.
What is the Smith Manoeuvre?
Smith Manoeuvre is a tax strategy that converts the interest you pay on the mortgage into a tax-deductible investment in Canada. It is also called the Canadian Tax Deductible Mortgage. This strategy was developed by Fraser Smith, who wrote a book about it in 2002.
In the United States, some homeowners can deduct their mortgage interest when filing their taxes by reporting it on Schedule A form. In Canada, the interest paid on your mortgage for your personal residence is not tax-deductible unless you do Smith Manoeuvre. In simple terms, Smith Manoeuvre is the simplest way to make your Canadian mortgage tax-deductible.
How Does it Work?
Using the Smith Manoeuvre, individuals can receive annual tax refunds, make their interest tax deductible, increase their net worth, and reduce the number of years on the mortgages. It would be best to have a readvanceable mortgage, which has a slight difference from a traditional or conventional mortgage, to do the Smith Manoeuvre.
A readvanceable mortgage is a combination of a Home Equity Line Of Credit (HELOC) and a mortgage. Your HELOC credit limit rises every time you make a mortgage payment. You can borrow additional HELOC funds to invest in a non-registered account for an investment that will produce income. This way, the interest on the loan becomes tax-deductible.
If you're based in Australia, make sure to compare home loans online.
When an individual pays their monthly mortgage payment, the mortgage principal that has been repaid that month is borrowed again under a line of credit. However, the borrower's net debt will remain the same because, for every mortgage principal that is repaid, another amount is simultaneously borrowed under the line of credit.
For someone who is engaging in the Smith Maneuver, the funds in the line of credit are then invested at a rate of return that is presumably higher than the interest rate on the line of credit. This is because the interest payment on the HELOC is tax-deductible.
If this technique is executed properly, it should result in a tax refund when a borrower files the income taxes in Canada. As a borrower, you can use your tax refund to pay down your mortgage, which in turn accelerates your mortgage repayment schedule.
There are two critical things to consider to be eligible; an individual needs to be a homeowner and also have the right type of mortgage, a readvanceable mortgage. However, it is important to note that not everyone can qualify for it.
If you’re hoping to buy a home, you will need to put down at least 20 percent to qualify for the readvanceable mortgage. But if you’re a homeowner, you will need to be having at least 20 percent equity for your home to be eligible for one.
Setting up Smith Manoeuvre
There are a number of steps you need to follow when setting up;
- Sign up for a readvanceable mortgage when buying your home, when the mortgage is heading for renewal, or by breaking the existing mortgage.
- Make regular mortgage payments which increase the HELOC credit limit.
- Borrow an additional HELOC space
- Invest it in a non-registered account for investments that will most likely earn a rate of return that is higher than the HELOC interest rate.
- Lastly, you can claim a tax deduction for the HELOC interest used for borrowing when filing your taxes. Then you can invest to receive a bigger tax refund.
There are a number of advantages you get when using the Smith Manoeuvre;
1. You can easily invest in the future without having to use your own cash flow because you will be using your home equity to invest. By doing this, you can always save for retirement even if you lack the cash flow.
2. When one borrows to invest, the interest will be considered tax-deductible, which means you can use it when the tax time comes.
3. You can pay off your mortgage sooner, especially if you use the tax refund to make a lump sum payment for your mortgage.
Risks and Disadvantages
While the Smith Manoeuvre is not a very complicated strategy, some risks and disadvantages are associated with it. However, the risks vary depending on your financial discipline, general state of the economy, risk tolerance, and investment horizon.
1. Lack of understanding of the tax rules. If you're unsure about the tax rules, it would be best to work with an accountant who understands the Smith Manoeuvre strategy.
2. Another major risk you're likely to experience is a lack of understanding of your risk tolerance. You need to be able to go through the down periods because if you don't, you probably won't reap the rewards in the long run.
3. A common disadvantage is that the net debt remains the same even after several years instead of being paid down like with a regular mortgage.
4. There is a possibility that the interest paid on the line of credit could be higher than the returns made on the reinvestments in the individual's investment portfolio.
5. If you're planning to attempt the Smith Manoeuvre, you need to be aware of the financial consequences when the house value falls. There is a possibility that one may become underwater on their mortgage, which basically means the situation where the loan is higher than the market value of the house.
How to Make Smith Manoeuvre Work For You
As mentioned above, the Smith Manoeuvre won't work for everyone, but how can you make it work for you? First, you should make mortgage payments on the readvanceable mortgage, increasing your HELOC. Then you can take the money out of HELOC and use it to invest.
Despite the fact that you will be paying some interest on your HELOC, you're going to get tax deductions, and the investments should be able to provide you a higher return than your interest rate. This will, in turn, result in net gains for you. Now that you have income bearing investment, you can always make those earnings work for you.
To do this, you can make additional payments on top of the regular mortgage payment, from the dividends paid out and the tax credit that you receive from the investment loan interest paid. With these payments, you will get an additional room in the HELOC to borrow for investments.
When you continue with this cycle, you'll get a much bigger portfolio, and you will also find out that you will pay off the mortgage sooner than if you wait until you have paid off the whole mortgage for you to invest. Also, the debt you will be having now is tax-deductible, whereas the mortgage wasn't.
Although this strategy will leave one with a large HELOC, there are some options you will have once the mortgage has been paid off;
- If your dividends are more than the interest, then you're better not paying off the debt because you have a net gain.
- You will be able to sell a portion of your stocks that equals the debt in order to pay it off.
- You can decide to reap the benefits of both options where you leave the investment portfolio untouched and continue paying the amount equal to what the mortgage loan payment was and use it to pay down the HELOC.
Readvanceable Mortgages in Canada
In Canada, the readvanceable mortgage offered by banks include:
- All in one HELOC- National Bank
- Home Equity Flexline- TD Canada Trust
- Scotia Total Equity Plan (STEP)- Scotiabank
- Home Power Plan- CIBC
- Homeowner ReadiLine- BMO
Smith Manoeuvre Example
For example, Mr. James has a home that is worth $1,000,000 and a mortgage of $500,000. Currently, he makes monthly payments of $3,500 for the mortgage, where $2000 goes to the principal, and $1500 is the interest fees.
From a readvanceable mortgage, Mr. James will have access to a HELOC limit of;
$800,000 ($1,000,000 x 80%) - $500,000= $300,000 HELOC funds available for investment.
The above calculation has taken into consideration the maximum amount the person can borrow is 80% of the value of his home. In addition to the $300,000, Mr. James will get an additional $2,000 to his HELOC when he pays the monthly mortgage payments. The additional amount is from the principal of the monthly payment he will make towards the mortgage balance.
Assuming Mr. James uses up to $100,000 to invest and the HELOC has an interest rate of 5.0%, then the interest expense would be $5,000, which is 5% of $100,000 will be deducted when the tax time comes.
Other Considerations On The Smith Manoeuvre
While the Smith Manoeuvre is a straightforward strategy, there are other considerations that you should always have in mind;
- There is a requirement to keep track of all the investments, interest payments, deductions, and dividends so that you can comfortably explain if the CRA decides to audit your income tax return.
- The investments should give a return that is more than the interest you're paying on the HELOC for the Smith Manoeuvre to make sense.
- The maximum HELOC plug the mortgage balance should not exceed 80% of your home's worth. This is because you don't have to use all the funds available in your HELOC. Only invest the money you're comfortable with.
- If you decide to use the earned income from dividends, rent, etc., as a down payment for your mortgage debt, then you will end up paying the mortgage faster.
- If your intention is not to use the income to speed up the mortgage payment, you can decide to go with the well-diversified funds, which can be held for a long time. This way, you will be transferring your capital gains to the future, and you can benefit from a more favorable tax rate on capital gains compared to interest and dividend income.
- Registered investment accounts, for example, TFSA or RRSP, do not qualify for the Smith Manoeuvre. The investment has to be held in a non-registered account.
- The Smith Manoeuvre is not recommended for risk-averse investors. As much as the leverage will amplify the gains, it might also worsen the losses. Always seek financial advice before executing the Smith Manoeuvre.
- It is important to note that the Smith Manoeuvre won't change the principal residence exception status of the home. This basically means that if you, later on, sell your home, it will not be subject to the capital gains tax.
- When you successfully pay off your mortgage using the Smith Manoeuvre strategy, you should be owning a sizeable investment account where you can either choose to keep your investments and continue paying the interest due on the HELOC investment loan or sell some investments to pay off the HELOC investment loan.
Frequently Asked Questions (FAQs)
1. Is HELOC(Home Equity Line of Credit) interest tax-deductible in Canada?
Yes. The loan interest is tax-deductible in Canada. The tax-deductible interest will apply if you use the money to buy, improve or build. The money has to be spent on a property whose equity is the source of the investment loan.
2. How Do You Know the Smith Manoeuvre Is Right for You?
The Smith Manoeuvre will make sense for people who have a long-term investment plan and are comfortable with borrowing to invest. If you plan to own a home for a long time, then the Smith Manoeuvre will make the most sense for you but won't for people looking to own a home for a few years, then rent it out later.
3. What Will Happen If You Move?
The mortgage lenders will have an option of "porting" your mortgage, which means you can move or transfer your readvanceable mortgage to your new home. You can also break the existing mortgage and take a new one.
4. What Happens When you Pay Off Your Mortgage?
When you pay off the investment loan, you will eliminate the non-deductible mortgage interest, but you will still be paying the tax-deductible HELOC interest. You will have the following two main options;
- To keep HELOC in place. However, this is recommended for the ones who are comfortable carrying the debt into retirement and are hoping to keep getting the benefits of the Smith Manoeuvre.
- The second option is to pay the investment loan down. You can redirect the cash flow that goes towards the mortgage into your HELOC.