Taxes are said to be one of the certainties in life. While we can’t avoid them, tax-efficient investing can help reduce your tax bill on investment income so you can keep more of your hard-earned savings.
It is important to understand that the amount of tax you owe on your investments varies depending on the type of account you hold and the type of investment income you earned.
Registered accountsRegistered accounts can be used to save for a variety of purposes, including retirement and education, and are subject to contribution limits. Registered accounts are tax efficient because you do not have to pay tax on income and gains when earned. Instead, tax is normally deferred, payable when amounts are withdrawn from the account. (The situation is different with Tax-free Savings Accounts, as explained below.)
For example, if you contribute to a Registered Retirement Savings Plan (RRSP) during your working years, the contributions can be deducted from your income, reducing your taxes payable. When you make a withdrawal from the RRSP (including when you convert your RRSP to a Registered Retirement Income Fund (RRIF) and begin making withdrawals), the amount will be added back to your annual income and will become taxable. However, many people making RRIF withdrawals are in a lower tax bracket than they were during their working years, so they benefit from the tax deferral.
A Tax-Free Savings Account (TFSA) is a registered savings account that is suitable for almost any savings objective. Contributions are made with after-tax dollars and withdrawals are tax free. This means that money can be earned in the account and withdrawn at any time without being taxed. TFSAs can hold the same investments as other registered accounts, but they are different from RRSPs because any amount withdrawn from the account is added back to contribution room for the following year. Unused contribution room can be carried forward indefinitely to future years.
Non-registered accountsNon-registered accounts can be used for short- or long-term saving and do not have contribution limits. With non-registered accounts, income and realized gains are taxed in the year earned – unlike registered accounts, non-registered accounts are not tax-deferred. The amount of tax payable is dependent on the form of income that has been earned.
Different forms of investment incomeBelow are the main forms of investment income and the way in which they are taxed.
|Form of income||Description|
|Interest||Interest is typically earned on investments such as bonds and is taxed at the same marginal tax rate as employment income.|
|Canadian eligible and non-eligible dividends||Canadian dividends are paid by Canadian public corporations to their shareholders, which include mutual funds that invest in the corporations. The Canadian government grants preferential tax treatment to individuals through the dividend tax credit.|
|Capital gains||Capital gains are realized when an investment is sold for more than was originally invested. Capital gains receive favourable tax treatment as only 50% of capital gains are taxable.|
|Foreign non-business income||Foreign non-business income can be considered dividends or interest from non-Canadian investments and is taxable at the same marginal rate as employment income.|
Corporate Class for tax efficiencyMutual funds are typically structured in two ways: as a trust or a corporation. Mutual funds structured as a corporation are called Corporate Class funds.
Corporate Class funds have the following tax-efficient features:
- Combined expenses for all investment mandates within the corporate class structure: Combining expenses can reduce interest and foreign dividend income within the corporate class structure, in turn reducing taxes, as interest income and foreign dividends are taxed at the highest rates.
- Tax-efficient distributions: Corporate class dividends are paid in the form of Canadian and capital gains dividends – currently the most tax-efficient sources of income.
- Low dividend payout policy: Capital losses from some corporate class funds may offset gains in other funds in the structure, which can reduce the potential for taxable distributions.
Tax-efficient cash flow with T-ClassT-Class funds are built on the corporate class structure and provide the additional benefit of tax-efficient cash flow. T-Class funds allow you to access cash flow from Corporate Class funds through regular monthly return of capital (ROC) payments, while maintaining the potential for growth in your portfolio.
Payments in the form of ROC are not taxable immediately because they represent a return of your original capital. However, ROC payments reduce the adjusted cost base (ACB) of your investment, which can lead to capital gains tax on the sale of the investment.
While tax-efficiency is an important factor to consider when investing, there are many other factors to consider, such as your goals, risk tolerance and time horizon.
A financial advisor can review your financial situation and recommend investments to help you achieve your goals.