With so many types of accounts and investment options available these days and given the complexity of Canada’s tax code, creating a financial portfolio that is tax effective can be a real challenge for the average investor.
“The first thing you need to do is to understand the nature of your investment income,” says John Waters, vice president and director of tax consulting services with BMO Wealth Management. “In evaluating investments for your portfolio, you should consider the impact of income taxes since not all investment income is taxed in the same manner.”
Generally, investors should take full advantage of registered (tax-sheltered) accounts before investing in non-registered accounts, as this is a very tax-efficient strategy.
If you cannot fully tax shelter all of your investments, you need to be aware that Canadian tax laws treat interest income, qualified dividend income, and capital gains differently and they are taxed at different rates.
Interest is the most highly taxed form of investment income and is fully taxable at your marginal tax rate. In contrast, you only pay tax on 50 per cent of a capital gain.
Canadian dividends also receive special tax treatment through the federal and provincial gross-up and tax credits.
The eligible dividends an individual receives from Canadian corporations are “grossed up” by 38 per cent. This amount is included on their income tax form as taxable income but both federal and provincial governments then grant a tax credit equal to a percentage of the grossed up amount.
The actual tax rates applicable to each income source vary by province or territory and with income level, but in general they are in the following descending progression:
The highest tax rates apply to interest income, premature withdrawals from your Registered Retirement Savings Plan (RRSP), dividends or distributions from non-Canadian sources, followed by Canadian eligible dividends in high income tax brackets and then capital gains. However, because of the power of the dividend tax credit, Canadian dividends are taxed very efficiently in low income tax brackets.
A tax efficient portfolio would place the highest taxable sources of income such as interest into registered accounts such as a Tax Free Savings Account (TFSA), RRSP, Registered Retirement Income Fund (RRIF), Registered Education Savings Plan (RESP), Registered Disability Savings Plan (RDSP), Locked In Retirement Account (LIRA) or Life Income Fund (LIF). Investments that produce capital gains and pay dividends would be more suited to non-registered accounts.
Riskier investments which may yield capital gains or losses are best suited to non-registered accounts where losses can be used to offset gains and reduce tax.
Some distributions from mutual funds are made up of what is known as return of capital (ROC). ROC is a tax term used to describe distributions which are in excess of the fund’s earnings. ROC often occurs when the objective of the fund is to pay a fixed monthly distribution to unitholders.
For tax purposes ROC represents a return to the investor of a portion of their original invested capital. Since the investor is receiving a portion of their original invested capital, payments are not taxed as income, thereby increasing tax efficiency.
ROC distributions, however, do impact the capital gains tax an investor is required to pay when they eventually sell the their investment as the ROC could cause the capital gain to be larger or the capital loss to be smaller.
Provided the beneficiary has started a post-secondary education, withdrawals from an RESP are generally taxed in the hands of the student who may end up paying little or no tax by using the basic personal exemption and the tuition credits. However, since the original capital contributed to the plan was from after-tax savings, its withdrawal is tax-free.
“At the end of the day, the most important thing is what is left in your pocket after paying tax,” Waters says. “This can be a complicated and confusing task, so it can really pay dividends to speak to a financial adviser to see what is best for you.”
Talbot Boggs is a Toronto-based business communications professional who has worked with national news organizations, magazines and corporations in the finance, retail, manufacturing and other industrial sectors.