Tax Efficient Investments

There are two certainties in life—death and taxes. The dreaded “T” word evokes memories of frantically trying to make sense of numerous tax receipts. Even Albert Einstein said, “The hardest thing in the world to understand is income tax.” If the world’s greatest genius had problems understanding taxes, it’s no wonder the average taxpayer does as well. Here are some basics on taxes and retirement investing that may help shed some light on the topic.

Understanding how your registered and non-registered investments are taxed is an important step in developing a suitable investment strategy. When it comes to choosing investments, you should carefully consider your investment objectives, time horizon, and risk tolerance. It is also important to compare the way different investments are taxed, because the amount of tax you pay can have a significant impact on your net profit from these investments. Investments grow tax-deferred within an RSP, which means they will not be taxed until they are withdrawn from the plan. However, outside an RSP, investment income is not tax-deferred, instead it is generally paid as it is received.

Over the long term, organizing a tax-efficient portfolio can save you thousands of dollars. When it comes to non-registered investments, investors pay the most tax on interest earned and the least on capital gains. Dividends fall somewhere in between. Here is an example. You make $20,000 on an investment. How you made this income that was generated will dictate how much tax you will have to pay and, the rate of your after-tax return.

A. Tax on Interest

Tax on interest is calculated at your full marginal tax rate, which varies depending on your income and province of residence. In some cases, you will pay up to 50% tax on interest income if you are in the highest tax bracket.

B. Tax on Capital Gains

Tax on capital gains is also calculated based on your marginal tax rate. The difference is that you are only taxed on 50% of your gains. Capital gains only need to be reported on your tax return when they are realized. For example, a $20,000 investment in the stock market five years ago may be worth $40,000 today, representing a $20,000 unrealized capital gain. The tax on these gains is deferred as long as the investment is held. Once sold, a tax liability would be incurred on the difference between the book value ($20,000) and the price at which shares were sold.

Remember that capital gains are transient values that fluctuate with time until they are realized. This can be a double-edged sword. Many unlucky investors will remember (all too painfully) the bursting of the dot.com bubble in early 2000, when highly inflated technology stock prices promising bountiful capital gains for scores of investors abruptly gave way to capital losses when the technology bubble suddenly burst.

C. Tax on Dividends

A dividend is a distribution to shareholders of a portion of a corporation’s earnings. Estimating the tax payable on dividends can often seem complicated to investors because companies pay tax on profits before distributing them to shareholders. Individual investors who receive dividends from a Canadian company are “grossed up” by 25% to represent the full value of the income the company is presumed to have made before tax. Then a federal dividend tax credit is applied to equal to 13.33% of the inflated figure reported on the tax return, plus an additional provincial dividend tax credit. The tax credits are designed to reduce the double taxation of business income earned through a corporation when distributed to shareholders.

D. What’s the Best Investment?

As a general rule, if you don’t need income, you should concentrate on accumulating capital gains. Timing can make capital gains more appealing than dividends from a tax perspective. Some investors will be able to defer capital gains for years, thus putting off their tax bill, however, this is not possible with dividends.

If you are looking to maximize your retirement income, you have a choice between dividend and interest income. The advantage of dividend paying investments is they offer a more tax efficient cash flow, usually outperforming interest-generating investments. Conversely, income producing bonds and fixed-income certificates such as GICs are more stable than dividend paying investments. However, as discussed earlier, the cost of investing in bonds compared with dividend paying stocks comes in the form of higher taxes on interest income. As each investor’s tolerance for risk differs, you need to have a careful discussion with your retirement income-planning advisor. Your specific risk tolerance and tax circumstances determines how much of each asset class to hold.

For investors who have enough money to maximize their RSP contributions each year and invest in non-registered funds, the most tax-efficient strategy is to hold their interest and dividend-bearing investments within the RSP, and hold capital gains-producing investments in the non-registered account. Different investment options will suit different investors at different times in their lives.