Chapter 1
Minimizing Taxes on Your Investment Income
In This Chapter
Choosing tax-smart investments
Paying less tax on your investments
We often hear people say, âMy taxes are too high. I wish there were a way to reduce them!â Although we donât have a magical solution that will make your tax bill disappear, we can suggest some things you can do to reduce the amount you pay, particularly if youâre an investor.
In this chapter we teach you the basics of tax-smart investing, how to pay less tax on your investments, and the rules of foreign investments. We also introduce some tax-advantaged investments you may not have thought of.
The Basics of Being a Tax-Savvy Investor
If you are an investor looking to maximize your returns, itâs not what you earn but what you keep after-tax that matters. Therefore, itâs necessary to consider many factors that are personal to you and which affect that after-tax return in order to properly construct an investment portfolio. These moving parts include your risk tolerance, your need for cash flow, the types of investment accounts you own, and your personal tax rate. A perfectly tax-efficient portfolio should not necessarily be your goal. First and foremost, choose investments that will allow you to sleep at night. But where itâs appropriate, choosing tax-efficient investments can help you keep more of your investment returns.
Tax efficiency doesnât matter when you own only registered investments or have a Tax-Free Savings Account. Why? Earnings in these accounts accumulate tax-free regardless of the type of return. Youâre taxed on your registered accounts only when you make withdrawals, and even then the type of underlying investment doesnât matter. The full withdrawal is taxed at your full marginal tax rate. Withdrawals from Tax-Free Savings Accounts are tax-free.
On the other hand, investment returns in a non-registered account (also called a cash account) are not created equal in the eyes of the taxman. In fact, the amount of tax you pay depends on the type of income your investment is earning, whether thatâs dividends, capital gains, or interest. To complicate matters further, the amount of tax on the different types of investment returns will differ depending on which tax bracket youâre taxed in. You also have to consider the impact of the investment income on other tax tested deductions, credits, or benefits you might qualify for such as the age credit, Old Age Security Benefits and medical credits.
Always weigh your investment and tax objectives before making any investment decision. Even though a particular investment suits you tax-wise, it may not fit your investment-risk profile.
You can also deduct a lot of investment-related expenses. Weâve got the details for you at
www.dummies.com/inaday/paylesstaxoninvestments.
Choose the best location for your investments
You may be lucky enough to have accumulated, over time, investment assets in registered, non-registered, and tax-free savings accounts. Some Canadians also have investment holding companies and maybe even family trusts or in-trust accounts for minor children. After you have more than one âlocationâ in which to make investment choices, consider where it makes the most sense, tax-wise, to make each investment.
First, determine your optimal asset allocation. Most people do this with the help of an investment adviser, and you should too. For this exercise, though, try to decide what types of investments you would ideally like to buy. It requires determining what percentage of your overall holdings you wish to invest in different types of assets, including cash (including high-interest savings accounts, money market funds, and shorter-term GICs), fixed-income investments (like government or corporate bonds, preferred shares, or longer-term GICs), and equities. Decide, too, what percentage of each asset class you wish to hold in different geographic locations, such as Canada, the United States, and globally.
After you figure out what you want to hold, you can choose the best location for each type of investment. You would generally want fixed-income investments inside your registered accounts, where that highly taxed interest income can be earned tax-sheltered. Dividend-paying Canadian equities are great in a non-registered account, so you can take advantage of the dividend tax credit. Equities that have great growth potential are a good choice for a TFSA, because the growth will never be taxable nor will the eventual withdrawal â so letting that account grow as much as possible makes a lot of sense. Depending on how much money you have to work with in each account, there will likely be some overlap as well. Thatâs okay. This is just a starting point.
Also consider the risk of each investment when choosing its location. For example, say you want to buy one stock that is more âspeculativeâ in nature. It could make you lots of money, or it could bust. You may want to buy that stock in your non-registered account. Why? If it does go bust, you would create a capital loss, which could be used to offset capital gains. If that stock goes bust in your registered account, the loss is useless to you.
Choose tax-smart investments
It pays to pay attention to how your various forms of investment income are taxed â like all things in taxland, each scenario has its pros and cons. In this section we look at tax-effectively managing your income from dividends, capital gains, and interest.
Canadian dividends have their advantages
A dividend is a distribution of a corporationâs profits to its shareholders after all expenses and income taxes have been paid. Investors receive dividends on the stocks they purchase in their investment portfolios. If youâre looking to generate dividend income, you want to invest in Canadian equities (either directly or via a mutual fund) that pay dividends annually.
Canadian dividends are a tax-efficient source of investment income because they qualify for a special dividend tax credit, which keeps the tax burden low. Canadian dividends are always taxed at a lower rate than interest income and are usually taxed at lower rates than capital gains. Dividends are taxed at higher rates than capital gains only in a few provinces at the higher tax brackets (weâre talking significant differences only, with about $100,000-plus of taxable income). Ernst & Youngâs website is particularly helpful in determining the tax rate that will apply to your income â use their tax calculator to find out, based on your current income level, what your marginal tax rate will be on regular income (including interest), dividends, and capital gains.
Dividends from public corporations resident in Canada â which is what you would normally hold in an investment portfolio â are called
eligible dividends; these must be included in your taxable income and grossed up by a set percentage that can differ every year. For example, if the dividend gross-up is 38 percent, the actual dividend received is multiplied by 1.38 or 138 percent). So, if you received $10,000 in eligible dividends you would have to include $13,800 in your income. The grossed-up dividend represents an estimate of what the dividend would have been had the corporation not been subject t...
