Tax efficiency is an important consideration when it comes to investing. After all, what really matters is the amount of money you have available to enjoy life, and meet your financial goals, not some abstract pre-tax rate of return.
In this article, we will discuss four specific strategies that can be used to reduce and/or defer taxes.
Strategy #1: Defer Taxes by Maximizing Your RRSP Contribution
One of the most popular tax deferral options used by Canadians is to invest in their RRSP (Registered Retirement Savings Plan). For most, this is a wise strategy. In addition to the tax deduction received in the year of contribution, all taxes on the growth of the investment are deferred until the money is withdrawn. The investor gets the benefit of the growth on the dollars that would have otherwise been paid in taxes; in effect it’s like an interest-free loan from the government.
Strategy #2: When all investments cannot be sheltered from tax, place the highest-taxed investments inside
Unfortunately, there are limits on how much can be contributed to one’s RRSP, leading individuals to invest some of their money outside of a registered plan.
This is where a more detailed understanding of Canada’s tax system is needed. The key point to understand is that different rates of tax are applied to different types of income.
Interest income, like that earned from GICs and bonds, is fully taxed at your marginal tax rate. Dividend income, from eligible Canadian corporations, is given a more favourable tax treatment, and capital gains, the profit realized from selling an investment, are taxed at the lowest rate.
The table below illustrates the level of tax applied to these three different types of income for an Ontario resident earning an annual income of $121,000 or more. Specific tax rates differ by province and income level; however, the same concepts apply.
It is beneficial, when structuring investments, to place the highest-taxed investments (GICs and bonds) inside your RRSP, and the most tax-efficient investments (equity mutual funds and stocks) outside the RRSP.
In the most extreme of circumstances, structuring investments in this way can reduce the tax on investment income by 50 per cent, or fully defer taxes until the capital gains are realized at some point in the future.
Strategy #3: Trigger capital losses strategically to offset capital gains.
Stock prices go up and down; it’s the nature of the market. While all investors strive for gains, losses, at least in the short term, will inevitably occur. These losses can, however, serve a useful purpose. Taxable capital gains can be offset by capital losses. In other words, if you lose money on one investment and make money on another, you only have to pay tax on the net gain. If you sell an investment that is in a profit position, you can reduce your tax liability by selling another investment currently experiencing a loss.
Unused capital losses can be carried forward indefinitely to offset future capital gains, or carried back up to three years to reduce previous taxable gains. Note, however, that the Income Tax Act disallows the deductibility of capital losses if the identical investment is repurchased within 30 days of the sale.
Strategy #4: Make use of unique tax structures such as T-series and capital class funds to defer taxes.
Some mutual fund companies have created special versions of funds to reduce or defer taxes. Some examples are T-series and capital class funds.
T-series funds defer taxes by paying you back your own money first. Since only gains are taxable, not the return of your own money, no tax is owed. Of course down the road, all that remains is the gain portion of your investment so all withdrawals from the fund become taxable at that point.
Capital class funds allow investors to change from one investment to another without triggering a capital gain. This allows investors to take advantage of different investment opportunities without creating a taxable event.
Other unique types of mutual funds convert some of the interest and dividend income generated by the underlying investments into capital gains. These concepts are more involved and beyond the scope of this article.
The Canadian tax system is complex. Knowing the ins and outs can save you thousands of dollars in taxes. Note that all these strategies have exceptions and that tax efficiency is only one factor in selecting an investment. Talk to your financial advisor to determine which strategies are appropriate for your particular situation.•
Four strategies to reduce your investment tax bill
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