It's not what you make. It's what you keep.
While your investments aren't beyond the taxman's reach, the right planning can help you keep more of your returns. Not all investment income is taxed in the same way, so it makes sense to evaluate what's in your portfolio to ensure it's minimizing what's taxable.
There are three basic types of income you can earn from an investment: interest, capital gains and dividends. While interest income is fully taxed at your marginal rate, dividends from eligible sources, such as shares* in Canadian public companies or mutual funds*, benefit from the Dividend Tax Credit. And in Canada, only half of a capital gain is subject to tax.
Reorganize. Restructure. Reduce.
If you're holding both registered and non-registered investments, how you structure your portfolio counts when it comes to saving taxes. Because interest income attracts the highest marginal tax rates, interest-generating investments like bonds* and savings accounts should be placed in an RRSP or TFSA. Then take advantage of the tax benefits of dividends and capital gains by leaving your equity holdings in a regular, unregistered account. By sheltering your highest taxed investments, you reduce your overall tax bill.
Here are four basic tax-saving strategies:
1. Tax-sheltered – protect your gains.
Aside from the immediate tax deduction, investments held in your RRSP grow tax-deferred. How much will it matter? If you're in a 40% tax bracket, $50,000 in term deposits paying 3% annually will grow-tax-sheltered to just over $90,000 after 20 years in an RRSP, earning about $19,000 in tax savings compared to a similar non-registered investment. Another benefit is that when you withdraw the money in retirement, you'll likely be in a lower tax bracket.
When you put the maximum of $5,500 annually into a TFSA, you don't pay any tax on the interest earned within the plan. Because there are no tax consequences to withdrawing funds (unlike RRSPs), the TFSA is an ideal way to save for short-term needs. If you're already maximizing your RRSP contributions, adding a TFSA is an effective way to shelter more of your income from investments.
If you're saving for your children's education, investments will grow tax-sheltered in an RESP. By starting an RESP before your child turns seven, the Province of British Columbia will put $1,200 into the child's RESP. The BCTESP grant requires no matching or additional contributions. You can also receive up to an additional $500 annually through the Canada Education Savings Grant to a maximum of $7,200 for the life of the RESP. When withdrawn, the income is taxed in the hands of the child, usually at a much lower rate.
2. Tax-preferred – reduce the tax.
Dividend investments like stocks* offer a tax advantage over other investments such as bonds† and term deposits. When held outside a registered plan, eligible dividends – generally those from Canadian public companies – can benefit from the Dividend Tax Credit.
Let's say you earn $1,000 in investment income. If you're in BC's top tax bracket, you'll pay $437 in tax if you received that $1,000 as interest, say from a term deposit. But if you earn it in dividends, you'll only owe $261 – that’s 40% less (based on 2012 marginal tax rates on dividends and interest for BC residents). Spread that tax reduction over even a part of your investment portfolio and the savings can add up.
Eligible investments with the potential for capital gains can also complement your strategy because only half the capital gain is subject to tax.
3. Tax-deductible – borrow to invest.
Loan interest paid on eligible investments is usually tax deductible. This means when you borrow to make an investment, the interest you pay on that loan is generally tax-deductible.
Paying down non-deductible debt first like a credit card balance is an investment in itself since the interest rates on credit cards are typically very high. For example, if you're in a 40% tax bracket, you would need to earn the equivalent of 30% on a guaranteed investment to enjoy the same after-tax benefit as paying down a credit card balance at 18% interest.
4. Tax-splitting – share the load.
If you have family members in various tax brackets, there are some simple ways to pay less on your combined investment income. If your spouse earns less than you, consider making a contribution to a spousal RRSP. You get the tax deduction and at retirement, having two similar-sized RRSPs will save tax over a single larger plan. Use your spouse’s disposable income for investing and use your income for expenses. Because they're in a lower tax bracket, a dollar of investment income earned in their hands will trigger lower tax consequences.
If your children are old enough to earn a part-time income, provide their spending money and let them invest their income. They're likely to pay little or no tax. If you give funds to your minor children to invest, choosing options that produce capital gains is tax-smart. Unlike interest income or dividends, any capital gains are not attributable back to you.