“It’s not what you make, it’s what you keep, after CRA wrings you out”
I think it is safe to say that nobody likes paying taxes (at least I haven’t found anyone in my lifetime who does). The more we make the more we are taxed. Therefore, it is important that we pay attention to setting up an investment portfolio correctly, in order to maximize tax savings. Here are a few ideas, some common, other less so:
(N.B: I am not an accountant or tax advisor. No points mentioned are intended to provide specific tax advice, only general, big-picture ideas. Please consult a licensed tax professional with regards to your unique circumstance)
Registered and Non-Registered Investments
Over the past 20+ years, many times an investor has said to me “I don’t bother with RRSP’s, they aren’t any good any more. You are going to get taxed down the road anyway”. Let’s clear up that misperception right now. When you invest in an RRSP this year, you save tax money that would have otherwise been sent to CRA this year. You save according to your top marginal tax rate, depending on your income bracket. For 2014, in Alberta the top marginal rate is 39%. In ON it is a whopping 49.53%! At a certain point, you pay close to 50% of every dollar earned to CRA. One of the best places for that money is to maximize RRSP contributions. You get to place that money into a plan in your name, earn investment returns on it, and pay taxes back many years down the road with tomorrow’s dollars. Those dollars should be worth less due to inflation. So essentially, you deferred taxes, and paid back in tomorrow’s dollars. What’s not to love about that? Don’t let misperceptions fool you.
Inside an RRSP, any income, capital gains, or dividends earned are not required to be declared in the year received. They are sheltered and deferred.
RRSPs and TFSAs
The difference between an RRSP and a TFSA (Tax Free Savings Account) is that with a TFSA you do not receive a tax deduction on dollars invested. The benefit is that you can earn income tax free inside the account, and never pay taxes upon withdrawal. It makes sense to maximize contributions to both plans, if you can, depending on your earned income and tax bracket.
These are investment accounts which do not provide tax deductions upon contribution. However, any interest income, taxable dividends, or capital gains realized must be paid within that calendar year.
General Structure of Investment Products Inside Various Plan Types
If you have a well-diversified portfolio, which is spread across various income distribution types, make sure you pay attention to how the income is taxed, and place those products in the right plan. For example:
RRSP- Because all income remains tax-sheltered, and is eventually taxed as income, you don’t necessarily require capital gains or dividend advantages in the RRSP. This means that the majority of your interest-earning investments can be placed here.
TFSA- If you have investments that generate regular dividend income, and reinvest, such as a stock, ETF or fund on the DRIP plan, it would make sense to place that type of fund here. That way you accumulate and reinvest dividends without having to worry about annual tax drag.
Non-Registered- Any investments that earn tax-advantaged income, such as capital gains or dividend income, can be invested here. In addition, any REITS or funds with a ROC (return of capital structure) are best held in a non-registered plan. The tax deferral, plus eventual taxes paid in the form of capital gains, can be maximized in non-registered plans. Flow-through investments, and other investments such as limited partnerships with up-front tax deductions, would be invested in a non-registered account also.
Keep in mind that, in reality, you should have a portfolio which is appropriate for your circumstance, risk tolerance, time horizon, and objectives first. For example, if you have a portfolio worth $500,000, and 400K is in RRSPs, you wouldn’t necessarily place 400K in interest-bearing investments only. You need to establish the appropriate mix first, then allocate the correct investments to the correct plan, to maximize tax savings. Never let the tax tail wag the investment dog, so to speak.
Additional Interesting Investment Structures
There are some investments which earn preferred interest income, and at the same time, provide common shares which represent additional potential value. An investor has the option to essentially split the investment into two separate accounts, in order to optimize tax planning. In this example, the preferred units would be placed inside an RRSP or TFSA, and the common units outside the RRSP. Interest income stays tax-sheltered. Common shares generate capital gains, therefore, any income they may produce would be preferable in a non-registered account.
Proper consideration of investment tax consequences, along with an appropriate investment portfolio, helps avoid costly mistakes.
It is extremely important to set up an investment portfolio which is appropriate for your needs. Going hand in hand with this, it is also important to ensure your potential tax savings are optimized within various investments and plans, so that you keep as much as you are entitled. I have seen many instances where tax optimization was not considered. Make sure your advisor is aware of this, and adds tax considerations into the investment conversation, to ensure your money is working as hard and as intelligently as possible.
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