Taxes can take a huge chunk out of your returns, which is where tax efficient investing comes in.
by Chris Amodeo
If you look through our website you’ll see some quotes that reflect our thinking, beliefs and points of view. One that sums up our thoughts on tax effective investing is by Robert Kiyosaki:
| “It’s not how much money you make, but how much money you keep, how hard it works for you and how many generations you keep it for.”
-Robert Kiyosaki |
Which is the point of this post — tax efficient investing and the key role it plays in building and growing your wealth.
Most investors consider their risk tolerance and asset allocation when putting an investment plan together, but what about the location of those assets? As you may know, asset allocation is the process of determining the appropriate balance of different asset classes such as fixed income, equities, cash etc., given your objectives and risk profile.
But determining where to put those investments is also important, since investment income is taxed differently depending on where your investments are held. Taxes have the ability to eat into returns and impact how much you keep. So understanding and considering the type of income an investment generates and the accounts you hold, will have an impact on your after-tax returns.
With that in mind, let’s have a look at the investment accounts available to Canadian investors and their taxable characteristics
In Canada there are two main types of accounts—registered and non-registered. Registered accounts, such as RRSPs and TFSAs, are tax deferral vehicles which allow you to defer tax and compound growth tax free—until you remove assets from the plan. Alternatively, non-registered accounts are taxable accounts and income is fully taxable in the year it is earned and, ultimately, are less efficient vehicles to compound your wealth. Understanding the types of accounts you have will help to determine where certain investments should reside.
Second thing to consider are the types of investments you own. Depending on the investment, there are three main forms of income: interest, dividends and capital gains — all of which are taxed differently. Interest income from bonds or GICs, received from Canadian or foreign sources, is fully taxed at your marginal income tax rate and is one of the least tax effective sources of income.
Most dividends paid by shares of Canadian companies, on the other hand, benefit from the dividend tax credit and have favorable tax rates. Eligible dividends received from Canadian publicly traded companies have an enhanced dividend tax credit, reducing the overall rate of tax on this income, making them an effective source of after-tax income.
Lastly, capital gains are the most tax efficient types of income for Canadian investors. Capital gains are only taxed when investments are sold, allowing you to indefinitely defer the tax burden, giving you the ability to choose the year in which you would like to be taxed. Additionally, only when an investment is sold for a profit will you have a capital gain, and only 50% of the net capital gain is taxable — reducing your tax rates by half.
This table shows how $10,000 of investment cash flow is taxed, depending on the form of income and how much money you keep if invested outside of registered accounts
| Income | $10,000=$4,647 after tax | Income – whether from employment income, interest-bearing investments or withdrawals from an RRSP or RRIF – is taxed at an investor’s full marginal rate. |
| Capital gains | $10,000=$7,324 after tax | Only half of a capital gain – realized when an investment is sold at a profit – is taxed at an investor’s full marginal rate. |
| Eligible Canadian dividends | $10,000=$6,066 after tax | Eligible Canadian dividends from a Canadian corporation are subject to a gross-up and dividend tax credit that reduces the taxes that are payable. |
| Return of capital | $10,000=$10,000 after tax | Return of capital (ROC) from Canadian funds allows taxes to be deferred. No tax is due when the return of capital is received, but the adjusted cost base (ACB) of the investment is reduced by the amount of the ROC. Taxable capital gains will be realized when the investment is sold or if the ACB goes below zero. Keep in mind that not all ROC is created equal. Some ROC is a return “on your capital,” essentially a distribution of unrealized gains accrued in the investment’s net asset value, while other ROC is a return “of your own capital,” which can occur if the investment’s net asset value is rising over time. |
*Based on an investor in the top marginal tax rate in Ontario for 2021.
As you can see, the amount of money you keep after tax varies on the type of income generated. Asset location can be as important as asset allocation and should be considered as part of an overall investment program.
Generally speaking, it’s better to keep fixed income investments that generate fully taxable interest income inside registered accounts and investments that generate capital gains and dividends in non-registered accounts.
Once you understand how to maximize your after-tax returns from asset location there is one other strategy that can help to grow your wealth. It’s the power of compounding. Compounding is basically money multiplying itself over time. This allows you to make money on the money you’ve already made.
Compounding is easier to do in a registered account, as income and capital gains are tax deferred. As an example, if you invest $10,000 in your RRSP and it grows to $20,000, when you sell the investment it will still be $20,000. Tax is deferred until you take money out of your RRSP.
If, however, you invest $10,000 in your non-registered account and it grows to $20,000 and you sell the investment, after tax you will be left with approximately $17,324. In these two examples the RRSP will compound from $20,000 going forward and the non-registered account will compound from $17,324, putting the non-registered account at a disadvantage. Therefore, to maximize the benefit from compounding outside your RRSP, take a longer term approach to investing and limit the amount of trading.
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Chris Amodeo is an Investment Advisor with CIBC Wood Gundy in Toronto. The views of Chris Amodeo do not necessarily reflect those of CIBC World Markets Inc. CIBC Wood Gundy is a division of CIBC World Markets Inc., a subsidiary of CIBC and a Member of the Canadian Investor Protection Fund and Investment Regulatory Organization of Canada. If you are currently a CIBC Wood Gundy client please contact your Investment Advisor. Clients are advised to seek advice regarding their particular circumstances from their personal tax and legal advisors.
Insurance services are available through CIBC Wood Gundy Financial Services Inc. In Quebec, insurance services are available through CIBC Wood Gundy Financial Services (Quebec) Inc.
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