There are many factors to consider when making investment choices, including return potential, asset class, level of risk and portfolio diversification. But one factor that's often overlooked is the amount of tax you will have to pay.
While the tax impact is not an immediate concern for tax-sheltered savings, it's an important consideration for any savings held outside a TFSA, RRSP, RRIF or RESP because interest income, dividends and realized capital gains are all subject to tax annually.
If you earn more than approximately $144,500 (for 2017) a year or have a high pension adjustment amount from an employer pension plan, annual RRSP contribution limits may keep you from saving what you need to create enough retirement income through an RRSP alone.
For higher-income Canadians, even modest retirement income goals, such as replacing 70% of your pre-retirement income, may be hard to reach through RRSPs. Chances are you will rely in part on TFSA or non-registered savings to maintain your desired lifestyle in retirement, and that's where the tax impact becomes significant. For non-registered savings, the after-tax return on investments is critical, because that's the money that goes into your pocket.
Here are 3 strategies to help you reduce taxes, stay ahead of inflation and move closer to achieving your financial goals.
1. Adopt a holistic approach
The first step toward tax efficiency is to consider all of your assets in the financial planning process. This includes registered and non-registered savings (including TFSAs), employer pension plans, real estate, cash-value life insurance, business assets and your spouse's assets, resources and savings.
This holistic approach to planning balances the importance of different financial needs. For example, a holistic approach recognizes why you would make regular contributions to a TFSA or retirement savings plan for tax-sheltered investment growth, but also sees the benefits of paying off a mortgage or debt in which the interest payments are not tax-deductible.
A holistic approach also means looking ahead to determine the taxes you may have to pay in retirement and taking steps now to reduce those taxes. This may include establishing a Spousal RRSP or setting up a trust for the benefit of your family.
2. Make the most of your investments in a registered or non-registered portfolio.
After you decide on an appropriate asset allocation (cash, fixed income and equities), arrange your investments in the most tax-optimal way.
For example, within RRSPs or TFSAs, consider holding investments that are taxed at the highest rate or have limited or no opportunity for tax deferral if held outside of a TFSA, an RRSP or a RRIF. These investments include:
- Regular GICs, index-linked GICs and market-linked GICs.
- T-bills, regular bonds and strip bonds (which are fully taxed as interest income each year, even though no annual income is received).
- Money market funds.
- Actively traded investments. You may want to hold sector rotation, momentum and other actively traded investments within TFSAs or RRSPs so capital gains realized each year are not subject to tax. However, depending on your circumstances and other holdings, they could be considered too risky. Also, you would lose the tax benefit of using capital losses to offset capital gains. Finally, be careful that the amount of trading conducted within a TFSA does not put it at risk to be considered to be carrying on a business by CRA.
Moreover, be careful about foreign withholding tax for foreign stock held within a registered account. If you hold the foreign stock in a non-registered account, you can claim a foreign tax credit against your Canadian tax payable for the amount of tax withheld. But if the foreign dividend is paid into a registered account, you can’t recover the foreign tax withheld and no credit is available. The Canada-United States tax treaty exempts U.S. dividends from withholding tax when paid to an RRSP or a RRIF. But that same break does not apply to a TFSA or an RESP, making U.S. dividend-paying stocks better off in RRSPs.
Other than TFSAs and RRSPs, consider holding investments that are subject to lower tax rates or that provide the opportunity for tax deferral. These include:
- Growth-oriented stocks and equity mutual funds, which produce mainly capital gains where only 50% of the gains are taxable.
- Preferred shares and other investments that produce dividends qualifying for the Canadian dividend tax credit.
- Growth investments that are bought and then held for the long term to maximize tax-deferred growth (for example, good quality growth and value-oriented equity funds).
- Certain mutual funds that seek to provide tax-efficient distribution through the distribution of dividends, capital gains or a return of capital.
3. Hold and defer.
Once you’ve established a well-diversified equity portfolio, hold it for the long term to defer capital gains and tax. Some of the benefits include:
- Increase in tax-deferred compounding. Built-up capital gains serve as extra capital on which to earn more money at pre-tax rates.
- Lower tax rates in the future. Not only will taxes on capital gains be postponed, but those gains may be subject to less tax in the future (if tax rates decline or if you move into a lower tax bracket).
- Less tendency to buy high and sell low. Many Canadians are buying high and selling low, a practice that severely reduces portfolio growth. Studies have shown that market timing is generally ineffective and rarely works on a regular basis.
Avoiding commissions and trading costs. The only guarantee with frequent trading is paying more commissions, loads in the case of load funds, and other trading costs.
The information in this article is general in nature. Get advice from a tax expert about your individual circumstances.