Investment strategies should take into account the many tax breaks available to investors. A dollar saved on income taxes is a dollar that can be invested to build wealth.
Canadians are generally aware of the tax-deductibility of contributions made to RRSPs and the fact that all investment returns within an RRSP are tax-deferred until the money is withdrawn – two important breaks that definitely help in the pursuit of a comfortable retirement.
But there are a number of less-well-known strategies that can make a big difference to after-tax returns.
In structuring a portfolio, for example, it is important to realize that not all cash received from investing is taxed the same.
Interest from bonds or business income from trusts is taxed like employment income (with a top marginal tax rate of 46 per cent in Ontario). But the effective top tax rate is only about 23 per cent on capital gains and 33 per cent on dividends, although this may drop to 21 per cent if Ottawa and the provinces follow through with a plan to cut the tax rate on dividends.
Another factor to consider is that the cash distributions from income trusts sometimes are partly ‘return of capital,’ which is not taxed immediately. Instead, the accumulated return of capital is taxed when the investment is sold, but only at the favourable capital gains rate.
To minimize income taxes, it makes sense, therefore, to keep income trusts paying a high proportion of cash as return of capital in a non-registered account while allocating income trusts paying mostly business income – taxed at the marginal rate – to registered accounts like RRSPs, RRIFs and RESPs.
Investors holding mutual funds in non-registered accounts should thoroughly investigate the ‘corporate’ version of mutual funds. When investors switch from one fund to another in managing their portfolios, the resulting trigger of income taxes acts as a drag on the accumulation of wealth.
To alleviate this, some mutual fund companies during the 1990s developed a corporate structure for mutual funds that allows investors to switch among any mutual fund that is within the corporation without triggering a taxable disposition. Most fund companies now offer the same fund in either a traditional or corporate version.
The drag from income taxes can also occur in equity funds that trade actively. As the resulting capital gains are distributed from these mutual funds, they are taxed, and this leaves investors with less after-tax with which to build their wealth.
Exchange traded funds (ETFs) are a viable alternative for investors wishing to avoid this tax hit. ETFs are normally invested in stocks that make up an index and while they do generate dividends, there is little buying and selling, and so they generate minimal capital gains distributions (although investors still participate in the rise or fall of the index).
Other breaks to consider:
– Resource tax shelters: All the money invested in a resource tax shelter can be deducted against other income (subject to minimum tax rules). The full amount is then taxed at a low capital gains rate when the investment is eventually sold.
– RESPs: Contributions up to $4,000 per year per child can be invested and effectively sheltered from tax until paid out for education, at which time they are taxed in the child’s hands.
– In-trust accounts: Money can be allocated to an in-trust account in the name of a child under age 18 and while the interest and dividends earned must be attributed back to the parent, the capital gains are considered the child’s.
– Deductibility of interest expense: If you borrow to invest (outside an RRSP), the interest is tax-deductible against regular income. Using this break, homeowners can make their make their mortgage interest tax deductible in the right circumstances (for example, if you cash in investments, pay down the mortgage, then increase the mortgage to raise funds to invest again, the interest on the increased portion of the mortgage is tax deductible as long as you keep the investment).
One important caution: never let the tax tail 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.
Wayne Cheveldayoff is a former investment advisor and professional financial planner. He is currently specializing in financial communications and investor relations at Wertheim + Co. in Toronto. His columns are archived at www.smartinvesting.ca and he can be contacted at wcheveldayoff@yahoo.ca.
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©2006 Wayne Cheveldayoff