Cut spending. Save money. Invest wisely. These are the three basic tenets for sound financial planning. But basic doesn’t mean easy. To invest wisely you need to consider diversification, volatility, the impact of fees, and the importance of tax planning.
In a low-rate environment, investors will turn to other ways to increase returns, such as reducing taxes owed on earnings. The amount of tax you pay will depend on four things:
- Where do you hold the investment (in a tax-shelter, such as an RRSP or TFSA?);
- The type of investment made;
- The tax laws where you live (municipal, provincial jurisdictions)
- Your income.
To take advantage of tax-planning strategies, an investor first needs to appreciate how different investments will trigger different taxes. To help, here’s a cheat sheet to taxes that impact an investor.
Capital Gains Tax
When you sell an asset for more than you paid for it, this increase in value is called a capital gain. (If you sell for a loss, it’s called a capital loss.) A capital gains tax is triggered whenever a profit is realized on the sale of an applicable asset, such as stocks, bonds, precious metals, real estate and property.
Investors need to be aware, however, that funds that hold multiple equities can also be subject to capital gains tax. For instance, a sale of shares in a mutual fund or exchange-traded fund can trigger capital gains (among other types of taxes) if the underlying assets fall under the Canada Revenue Agency’s definition of a “non-inventory asset”.
The tax owed is calculated based on your marginal tax rate and you only owe tax on half the profit you earned. Another advantage is that you won’t have to pay the tax until you’ve sold the asset.
A dividend is money paid to shareholders by a company out of its after-tax profits. This means the taxman has already taken a cut and, as a result, gives shareholders a break on the taxes owed on that earned money.
But the calculation to get that break can get a little tricky. That’s because the CRA uses a gross-up rate to calculate the tax owed (this rate takes into consideration that a corporation has already paid tax on the dividend sum) before an individual investor can apply for a dividend tax credit.
Here’s how it works: Assume an investor earns $200 in eligible dividends. To calculate the tax owed, the investor would add 38% to the amount earned (the “gross-up”).
$200 x 138 (38% gross-up) = $276
Then, the CRA will allow you to apply a federal credit towards the total “earned” sum (in this case $276). This credit can be calculated using a per cent or a fraction, as follows:
- PERCENT: $276 x 15.0198% (as of 2018) = $41.46
- FRACTION: $276 x 6/11 = $41.56
The purpose of the credit is to balance things out for the investor by taking into consideration the tax paid by the corporation. Plus, many territories and provinces will also offer dividend credits, as well.
Investors must keep in mind that only qualified dividends — earnings paid out by companies domiciled in Canada or in a country that has a double-taxation treaty with Canada, like the U.S. — are considered eligible dividends. Private Canadian corporations will pay out non-eligible dividends and are subject to 15% gross-up (for 2019 earnings and later years) and a 9% tax credit. Dividends from foreign countries are not eligible for the dividend tax credit.
Tax on Interest
Interest is earned on products including (but not limited to) bonds, GICs and high-interest savings accounts.
When an investor earns interest, 100% of those earnings are taxed. The tax paid is based on your marginal tax rate (which depends on your overall income).
This is one reason why what you earn can greatly impact the amount of tax paid on investment earnings.
Income tax is owed on any earnings made due to contracts, salaries, hourly wages or commissions.
Income tax is calculated based on tax brackets — these brackets increase as income increases, with those earning less, theoretically, paying the least amount of tax.
How to Save on Taxes
While tax planning can get quite complicated, there are some basic rules of thumb that will apply to most investors.
#1: Use tax shelters
The Registered Retirement Savings Plan (RRSP), the Tax-Free Savings Account (TFSA), are two of a number of tax-shelters that help investors to legitimately minimize taxes owed on investments.
For instance, the TFSA allows a person to invest after-tax dollars. Any earnings — regardless of the type — are not taxed when money is withdrawn from the TFSA.
An RRSP allows a person to invest before-tax dollars. The investor then gets a tax credit on their current tax-year return and defers having to pay the tax earned on these investments until they withdraw the money (theoretically at a future time when their marginal tax rate is much less, say in retirement).
#2: Strategize where to put investments
Because different investments attract different taxes, it’s best to strategize where you hold those investments.
For instance, GICs, bonds and other debt-instruments are best held in TFSAs and RRSPs, rather than in an unregistered account. These investments attract interest earnings, which are 100% taxed at your marginal tax rate.
Dividend producing assets that are expected to appreciate in value (a capital gain) are best held outside of tax shelters unless you have contribution room and then you might as well shelter these investment earnings, as well.
But what about real property? For most investors, there is no option. A rental property cannot be held inside a tax-shelter and all rental earnings must be declared as income and taxed at your full marginal tax rate.
For more sophisticated real estate investors, it is possible to set up a self-directed RRSP that holds a mortgage — an interest-bearing debt investment. To do this, an investor will lend themselves capital (usually from other investments) to finance their own mortgage, which will now be held inside a self-directed RRSP. Instead of paying the bank the mortgage principal payment and the interest, you now pay yourself the mortgage payment and the interest. This provides a healthy fixed-income return and defers tax owed on the interest earnings. To work, the mortgage provided by the investor must be non-arm’s length (ie: to themselves or a family member) and for a property where there is no more than four units, one of which is occupied by the owner and with a market value of less than $1-million CDN.
#3: Prioritize the goals
Despite all this focus on tax planning, it’s important to keep in mind that minimizing taxes is not the primary reason for selecting an investment or creating an investment strategy. The best investment decisions are based on a sound financial plan — and this should take into consideration timeframe, risk aversion, volatility, fees as well as tax planning.