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Tax tips to keep in mind when investing

by Wayne Cheveldayoff, 2004-03-18

Investment planning should always take into account the many tax breaks available to investors. A dollar saved now on income taxes is a dollar that can be reinvested and used to build a larger retirement portfolio.

However, investors should be careful and use tax breaks only if they fit right. The tax tail should never wag the investment dog – meaning that tax considerations should never overwhelm the first priority of investing, which is to make sure your portfolio is properly diversified and will grow over time.

Most Canadians are already familiar with the ‘big three’ registered, tax-shelter plans for investments, namely RRSPs, RRIFs and RESPs. Money put into an RRSP is tax-deductible up to certain limits, and any investment gains (interest, dividends or capital gains) earned in all three of these plans are sheltered from tax until money is withdrawn, at which time the withdrawals are regarded as fully taxable income.

Beyond these registered plans, there are a number of less-well-known tax breaks that can make a substantial difference in after-tax returns.

Key for investment planning is the fact that different effective tax rates apply to different types of investment gains. In Ontario, for example, someone already in the top income tax bracket would be subject to a 46-per-cent tax rate on interest income. But the effective tax rate would be only about 33 per cent on dividends and 23 per cent on capital gains.

With these substantial differences, it makes a lot of sense to place interest-bearing investments in an RRSP and focus non-registered investing on securities with the potential for capital gains and dividends.

Distributions from income trusts can have varying proportions of fully taxable income, dividends, and tax-deferred payments (known as return of capital and which are eventually effectively taxed as capital gains when the trust units are sold). Trusts with distributions that have a high proportion of return of capital make more sense outside of a registered plan than within it.

Parents can also save taxes when investing on behalf of children. For example, you can set up a separate bank account under your child’s name to deposit Child Tax Benefit cheques. As long as the child’s income is less than the basic personal amount (just under $8,000), the money will earn interest tax-free.

Money invested for children in in-trust accounts at brokerage houses is also subject to favourable treatment. While interest and dividends earned in such accounts are attributed back to the contributing parent who must pay income tax on them, any capital gain is taxed in the hands of the child. Thus, in the absence of other income, a child could have taxable capital gains of almost $8,000 a year without paying tax.

When parents are putting away funds for university or college, it can be advantageous to invest in interest-bearing securities in an RESP (since withdrawals will be taxed in the hands of the child when withdrawn for tuition and living expenses) while reserving the in-trust account for securities with capital gain potential.

As for deductions that can reduce tax payable, Canadians can reduce taxable capital gains by the amount of capital losses they have. If they cannot be used in the current year, such losses can be carried back three years or ahead indefinitely.

Deductions are also allowed for “carrying charges” related to investments, such as safety deposit box fees and certain fees paid to an investment counsel. This latter deduction is only for money invested through an investment counsel that charges you fees directly for managing your money and not for money invested in mutual funds.

For those with large portfolios ($250,000 and over) now invested mainly in mutual funds, consideration should be given to using an investment counsel in order to make use of this deductibility of fees. However, it would be wise to consult a tax accountant prior to making any move since the Canada Revenue Agency has fairly specific rules on what is eligible for this deduction.

The Agency does not allow the deduction of administration fees paid for RRSPs and RRIFs or subscription fees paid for financial newspapers, magazines or newsletters. Brokerage commissions are not deductible from current income, but are deducted from the proceeds when an investment is sold to determine the capital gain or loss.

You can deduct the interest paid on loans taken out to make investments but only in certain circumstances. You can deduct the interest if you use the borrowed funds to try to earn investment income, including interest and dividends, but not if the only earnings your investment can produce are capital gains.

In fact, this deductibility provision is the cornerstone of a strategy that can make home mortgage payments tax deductible. If you have both a home mortgage and non-registered investments, you can cash in the investments, pay off the mortgage, and then borrow again against the home to make new investments. The interest on the new borrowings should be tax deductible. However, anyone wanting to do this should consult a tax accountant. If there are substantial capital gains taxes to pay when the original non-registered investments are sold, it may not make sense to do it. Also, it is important to get advice on how to create a paper trail that would satisfy a tax auditor.

You can additionally deduct any interest charge incurred when you buy Canada Savings Bonds through payroll deductions, but you cannot deduct interest on money borrowed for contributions to RRSPs and RESPs.

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©2004 Wayne Cheveldayoff