It’s that time of year when we are all thinking about taxes. There are three forms of investment income in Canada: interest, dividends and capital gains. Each type of income taxed differently. Understanding the difference and how to use these differences to your advantage can provide considerable tax savings every year.
Since the preferential tax treatment of Canadian dividends, capital gains and return of capital is lost when earned in and withdrawn from an RRSP/RRIF, the following is a general rule of thumb that should be considered when determining your ideal investment allocation.
Hold your fixed income or interest bearing investments, such as bonds and GICs, in your registered accounts (RRSP/RRIF and Locked-in Retirement Account - LIRA) and hold your equity investments, such as common stocks, preferred shares and equity mutual funds, in your nonregistered account.
The other consideration is that Interest income earned on these bonds or GICs is taxed at your highest marginal rate. If you are in the 43.4% tax bracket and you earn 3% on a bond, you have to send 1.3% of the 3% to CRA and are left with a 1.7% after tax return. If the same bond was held inside your RRSP or RRIF, you would keep the entire 3% no investment income is taxed inside these accounts.
other consideration is Canadian dividends which are taxed at a much lower rate due to the Canadian Dividend Tax Credit. If you are in the same 43.4% marginal tax bracket, you will pay 25.4% tax on Canadian eligible dividends versus the 43.4% on interest income earned on the bond. This represents a 41% tax savings. For this reason, you can maximize your after-tax income by holding equity-based investments that generate Canadian dividends, capital gains or return of capital income in your non-registered account. However, these investments typically carry higher risk due to their market value, fluctuating more in price than more conservative fixed income investments, and may offer greater returns or losses. So your overall asset mix and risk tolerance are important considerations.
Want to learn other tax saving strategies? Join us for one of our “Ten Strategies to Pay Less Tax” workshops in April.