There is good news and there is bad news. Bad news first. The bad news is, regardless of what you do with your investments, the taxman will somehow get their money. The good news is, there are ways to structure your investments so that the amount of money going to the taxman is minimized. Not all investment income is taxed in the same way, so spending some time on building a tax efficient portfolio can help minimize the total tax you will pay on your investment income.
Before you can build your tax efficient portfolio, some background information. Generally, there are three types of investment income that you can earn:
1. Interest income (for example, high interest savings accounts, government bonds, corporate bonds, etc.)
2. Capital gains (for example, when you sell an investment, you could have a capital gain or loss on the sale)
3. Dividend income (for example, if you hold shares of Canadian corporations such as Bell Canada, you may receive a quarterly dividend)
It is important to understand how each type of investment is taxed. For purposes of this analysis, I have assumed that the taxpayer is in the second highest tax bracket in Ontario (income between $135,000 and $509,000). For 2013, the following tax rates would apply to investment income held outside of an RRSP/TFSA/RESP:
Interest Income- 46.41%
Capital Gains- 23.20%
Dividend Income- 29.54%
You can see that the above rates vary significantly depending on what type of investment income you have. Interest income of $100 would attract $46.41 in taxes compared to only $29.40 if you had $100 in dividend income. That’s a big difference! By structuring your investments in the right way, you may be able to avoid paying tax on all your interest income and defer paying tax on your other investment income. Sounds like a great idea, right? Lets discuss.
Once you’ve selected the investments you want to buy (or you may already own them), you need to decide what type of account to put them in. Generally your options are as follows:
- RRSP, TFSA and/or RESP (Registered Accounts)
- Non-Registered (although this doesn’t have a cool acronym like the others, simply put this is a catch all for anything other than the above).
An RRSP account allows all investment income to accumulate on a tax deferred basis (in addition to an immediate tax deduction). That tax deferral can add up over time thanks to a wonderful thing called compounding! For example, a $100,000 investment inside an RRSP earning 5% per year would be worth $339,000 after 25 years thanks to compounding. If you had to pay tax on the investment income every year (based on the 46.41% rate above), that same investment earning the same 5% return would only be worth $195,000 after 25 years. Big difference, ehh! Now after 25 years when you withdraw the money from your RRSP you will have to pay tax at that time, but hopefully you you be in a lower tax bracket at that time.
A TFSA account does not attract any tax at all just as its name suggests, regardless of what kind of investment income you earn.
An RESP allows investments to grow on a tax deferred basis. When withdrawn, income is taxed in the hands of the child, usually at a much lower rate and often times will not attract any tax. Additionally, you can get the added bonus of up to $500 annually thanks to the Canadian Education Savings Grant program (lifetime maximum of $7,200 per child).
Non-registered accounts do not receive any special tax treatment. The rates outlined above apply to investment income earned in non-registered accounts.
The Tax Efficient Portfolio
Now that you have an understanding of the tax rates applicable to the various types of investment income and the different ways you can hold your investments, lets talk strategy.
Investments that generate interest income should be held first in your TFSA then in your RRSP/RESP once you’ve used up your TFSA contribution room. Interest income attracts the highest rate of income tax, however if you hold it in your TFSA, your tax bill disappears! If you hold them in your RRSP, while you will ultimately be taxed when you withdraw from your RRSP, you will benefit from tax-deferred compounding.
Investments that generate dividend income from Canadian corporations should first be held in a non-registered account. Because of something called the “Dividend Tax Credit”, an individual with no other sources of income could receive almost $50,000 of eligible dividend income TAX FREE. This dividend tax credit still applies if you have other sources of income, however it results in a reduced tax rate on your dividend income as you’ll note above (29.54% compared to 46.41%). If you’ve got room left in your TFSA/RRSP/RESP after allocating all your interest earning investments to these accounts, then you should put balance of dividend earning investments there.
Investments that generate capital gains (or losses) should be held in either your non-registered account to take advantage of the lower tax rate on capital gains, then your TFSA if you have any room left. You can also put them into your RRSP if you have contribution room left over. A word of caution though- for ‘higher-risk’ investments that could generate a capital loss just as easily as they could generate a capital gain. If you hold these investments in your TFSA or RRSP, you lose the benefit of offsetting capital gains with these losses that you would have otherwise been able to do in your non-registered account. Therefore, it almost always makes sense to keep these ‘higher-risk’ non-blue chip type stocks in your non-registered account.
As you can see, the general idea is that investments which attract higher rates of tax (eg. interest income) are better put into accounts that either eliminate (TFSA) or defer (RRSP/RESP) the tax on that income. By using this general strategy, you can reduce your tax bill from your investments and let your two best friends go to work for you: time and compounding.
Other Considerations:
Here are some other, though not as common, situations that are still worth mentioning:
- Dividends from US corporations are best held in your RRSP. These dividends do not get the benefit of the Dividend Tax Credit that dividends from Canadian corporations do. Additionally, if not held in your RRSP, there is an automatic 15% withholding tax that gets withheld by the US corporation paying the dividend. If held in your RRSP, there is no withholding tax. If held in your non-registered account, you can often recover some or all of the withholding tax through a withholding tax credit. If held in your TFSA, you can’t recover the withholding tax.
- Other Foreign Dividends from a country that does NOT deduct withholding tax when held in your RRSP. If taxes are withheld regardless of what account they are held in, your non-registered account is the way to go as you can claim some or all of the withholding tax back through a withholding tax credit. If held in your TFSA, you can’t recover the withholding tax.
- If you borrow money to invest (other than for short-term purposes of making an RRSP contribution for example), make sure you hold the investments in a non-registered account as you can deduct the interest from the investment income earned. If held in your RRSP/TFSA/RESP, you are not able to deduct the interest that you pay.
While it is difficult to control and have certainty around your investment returns, with some prudent planning you can build a tax efficient portfolio to maximize your after-tax investment returns.
If you would like to discuss how to build a tax efficient portfolio as outlined above, or any other tax strategies, please do not hesitate to contact us.
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