There are many factors to consider when making investment choices, including return potential, asset class, level of risk and portfolio diversification. But one factor that's often overlooked is the amount of tax you’ll have to pay.
While the tax impact isn’t an immediate concern for tax-sheltered savings, it's an important consideration for any savings held outside a TFSA, RRSP, RRIF, RESP or RDSP, because interest income, dividends and realized capital gains are all subject to tax annually.
If you earn more than approximately $162,278 (2022) a year or have a high pension adjustment amount from an employer pension plan, annual RRSP contribution limits may keep you from saving what you need to create enough retirement income through an RRSP alone.
For higher-income Canadians, even modest retirement income goals, such as replacing 70% of your pre-retirement income, may be hard to reach through RRSPs alone. Chances are you’ll rely in part on TFSA or non-registered savings to maintain your desired lifestyle in retirement. Understanding the tax treatment of investment income earned in non-registered savings accounts may help you to minimize the tax you pay, so you can keep more money in your pocket.
Here are 4 strategies to help you reduce taxes, stay ahead of inflation and move closer to achieving your financial goals:
1. Adopt a holistic approach
The first step toward tax efficiency is to consider all of your assets in the financial planning process. This includes registered and non-registered savings (including RRSPs, TFSAs, employer pension plans, real estate, cash-value life insurance, business assets) and your spouse's assets, resources and savings.
This holistic approach to planning balances the importance of different financial needs. For example, a holistic approach recognizes why you’d make regular contributions to a TFSA or RRSP that may reduce tax on investment earnings. But it also sees the benefits of paying off a mortgage or debt in which the interest payments aren’t tax-deductible.
A holistic approach also means looking ahead to determine the taxes you may have to pay in retirement and taking steps now that may help reduce those taxes. This may include establishing a spousal RRSP.
2. Make the most of your investments in a registered portfolio
After you decide on an appropriate asset allocation (cash, fixed income and equities), consider arranging your investments in a way that may minimize taxes. For example:
Within RRSPs or TFSAs, consider holding investments that are fully taxed or that have limited or no opportunity for tax deferral if held outside of a TFSA, an RRSP or a RRIF. These include:
- Regular Guaranteed Investment Certificates (GICs), index-linked GICs and market-linked GICs
- T-bills (Treasury bills), regular bonds and strip bonds (which are fully taxed as interest income each year, even though no annual income is received.)
- Money market funds
3. Consider actively-traded, foreign and growth investments
If you have a higher risk tolerance and prefer to invest in more growth-oriented or actively-traded investments, you may want to hold them within TFSAs or RRSPs so capital gains realized each year aren’t subject to tax. Be aware that you’d lose the tax benefit of using capital losses to offset capital gains. Finally, be careful that the amount of trading conducted within a TFSA account doesn’t risk it to be considered to be carrying on a business by the Canada Revenue Agency (CRA).However, be careful about foreign withholding tax for foreign stock held within a registered account. If you hold the foreign stock in a non-registered account, you can generally claim a foreign tax credit against your Canadian tax payable for the amount of tax withheld. But if the foreign dividend is paid into a registered account, you can’t always recover the foreign tax withheld because no credit is available. The Canada-United States tax treaty exempts U.S. dividends from withholding tax when paid to an RRSP or a RRIF. But that same break doesn’t apply to a TFSA or an RESP, making U.S. dividend-paying stocks better off in RRSPs.
If you’ve maximized contributions to TFSAs and RRSPs, consider holding investments that are subject to lower tax rates or that provide the opportunity for tax deferral in your non-registered accounts. These include:
- Growth-oriented stocks and equity mutual funds, which produce mainly capital gains where only 50% of the gains are taxable.
- Preferred shares and other investments that produce Canadian dividends qualifying for the Canadian dividend tax credit.
4. Hold and defer
Once you’ve established a well-diversified equity portfolio, hold it for the long term to defer capital gains and tax. Some of the benefits include:
- Increase in tax-deferred compounding: Built-up capital gains serve as extra capital on which to earn more money at pre-tax rates.
- Return of capital: Investments that distribute a return of capital may also help to defer tax since the future distribution is taxed as part of the capital gain when the investment is sold.
- Lower tax rates in the future: Not only will taxes on capital gains be postponed, but those gains may be subject to less tax in the future (if tax rates decline or if you move into a lower tax bracket).
- Less tendency to buy high and sell low: Many Canadians are buying high and selling low, a practice that severely reduces portfolio growth. Studies have shown that market timing is generally ineffective and rarely works on a regular basis.
- Avoiding commissions and trading costs: Frequent trading often results in paying more commissions and other trading costs.
The benefits of this strategy should be regularly weighed against the investment outlook for the individual investments.
The information in this article is general in nature. Get advice from a tax expert about your individual circumstances.