Welcome back to the blog!
In addition to working with clients on investment and wealth management, I write a quarterly blog on tax tips and tidbits.
In this edition, I’ll outline some thoughts on the importance of building a tax-efficient portfolio given that not all investment income is taxed in the same way.
So how is my investment income taxed?
It is officially spring and that means that it is also tax season!
This can be an anxious time of year for some where procrastination is commonplace, however, eventually a shoebox of slips, receipts, and documents is sent to an accountant. Often included in the pile of documents are T3s, T5s and brokerage statements reporting investment income and gains and losses for the calendar year.
Now, let’s start with a review of the types of investment income reported on these documents and how it is taxed before we get to trying to minimize the tax man’s take!
Interest, it is earned on investments such as GICs, bonds or savings deposits and it is fully taxable at the same marginal rate as ordinary income.
Canadian Eligible Dividends, these are paid by Canadian public corporations and get special treatment as they are paid from after-tax dollars, so the effective tax rate after the “gross-up” and tax credit results in a reduced tax rate in comparison to interest.
U.S. and Foreign Dividends, these are not so lucky to get special tax treatment and are taxed at your same marginal rate as ordinary income or interest noted above. Further, foreign withholding tax typically applies that is not always recoverable, more on this later…
Capital Gains, if an investment is sold for more than its purchase price, the difference is a capital gain, and currently, one-half of this amount is taxable at your marginal rate. Capital gains are therefore generally more tax-efficient than interest or dividends.
Return of Capital, it represents a return of an investor’s original invested capital and is not taxable at the time it is received. However, it reduces the cost base of the investment, which results in a larger capital gain when it is sold at a later date.
The basics ins and outs of tax-efficient investing
Okay, so we’ve tackled the basics and looked broadly at how the different types of investment income are taxed.
Now, in creating an investment plan, giving consideration to asset allocation - the right balance between stocks, bonds, real estate, or other investments that make up a portfolio - is commonplace. However, in order to ensure a portfolio is structured tax efficiently, a savvy investor also considers asset location - the distribution of assets across RRSPs, TFSAs, and taxable accounts - as each account is governed by different tax rules.
In order to minimize the tax man’s take through optimal asset location, I’ve outlined a few general guiding principles and rules of thumbs to ponder:
Income earned or capital gains realized in these accounts is tax-deferred, which means it is not taxed as received, and as such, the income and growth compounds until funds are withdrawn at which time it is taxable as regular income at your marginal rate.
- Consider holding Canadian and U.S. interest-earning investments as this income is normally fully taxable at your marginal tax rate. Further, consider investments that receive U.S. dividends as these are exempt from withholding tax under the treaty.
- Generally, it is best to avoid investments earning foreign (non-U.S.) interest or dividends as withholding tax may apply that can’t be recovered through a foreign tax credit. Similarly, a tax credit cannot be claimed for Canadian dividends, and as such, the preferential tax treatment is lost. Finally, the preferential tax treatment afforded to capital gains is also lost inside these accounts while capital losses also can’t be utilized.
Income earned or capital gains realized in this account are not taxed as earned or when funds are withdrawn.
- Consider holding Canadian and U.S. interest-earning investments (see above) or investments that receive Canadian dividends or realize capital gains - the preferential tax treatment is lost, however, there is no tax on the withdrawal.
- Generally, it is best to avoid investments that receive U.S. or foreign interest and dividends as there is no treaty exemption on withholding tax for a TFSA as there may be in an RRSP, and further, a foreign tax credit cannot be claimed to recover any withholding.
Personal Taxable Account
Income earned or capital gains realized in this account are taxed annually.
- Consider holding investments that receive Canadian dividends or realize capital gains given the preferential tax treatment and lower effective tax rates. In addition, consider U.S. and foreign investments that receive dividends as the withholding tax may qualify for a foreign tax credit. Finally, investments that make non-taxable return of capital distributions are best held in a taxable account as this is a tax-efficient means of obtaining regular cash flow.
- Generally, it is best to avoid any investment that earns Canadian or foreign interest as it is fully taxable at your marginal tax rate and therefore the least tax-efficient.
Investment income in private corporations is beyond the scope of this blog given that corporations are subject to different tax rates, more complex tax rules involving passive income, and additional estate planning considerations.
So why does this all matter?
It isn’t just what you earn, it’s what you keep.
If you want to keep more of what you earn as an investor, tax efficiency is important, and paying attention to the type of income each investment generates as well as the account that the investment is held in is likely to have a real impact on after-tax return.
Given that investors save for long-term goals such as retirement over a number of years, a difference of a percentage point over a long time horizon with the effect of compounding may make the difference between a comfortable retirement versus a frugal one.
Finally, although tax efficiency is important, it shouldn’t be the starting point of constructing an investment portfolio - it should only be considered after determining the appropriate asset mix for your goals and risk tolerance.
In other words, the tax planning tail should not wag the investment policy dog - and this is coming from a former tax accountant.
This blog and article may contain strategies, not all of which will apply to your particular financial circumstances. The information in this article is not intended to provide legal, tax or insurance advice. To ensure that your own circumstances have been properly considered and that action is taken based on the latest information available, you should obtain professional advice from a qualified tax, legal and/or insurance advisor before acting on any of the information in this article.
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