This is the season when many of us are busy preparing income tax returns, perhaps a good time to reflect on the taxes we pay in investing. Just as investments benefit from compounded growth over time, the tax on income and gains can accumulate to become significant.
First, recall the different ways that investment income is taxed in non-registered accounts. Interest income is fully taxable at an investor’s marginal rate. Capital gains are taxed at half of this rate since only half of a capital gain is taxable. Eligible dividend income from Canadian corporations generally attracts tax at a rate in between the two.
So how do different taxes impact returns over time? The table below illustrates four scenarios (A to D), each involving an investment of $50,000 at Year 0 and an annual rate of return of 6 percent compounded over 25 years. In A and B, tax is paid each year at different rates based on the type of income earned: interest and dividends. In C, taxes are deferred so there is no annual tax, but tax is paid at year 25 when capital gains are realized. In D, there is no tax; funds grow in a TFSA. After 25 years, the difference in after-tax value is significant. As such, it is prudent to consider making investments more tax efficient where possible.
This includes ensuring that you maximize tax-advantaged accounts like TFSAs, RRSPs and others. Consider also the opportunity to consolidate accounts, to help optimize asset location across all of your accounts.
Certain types of investments may have tax-advantaged attributes. For instance, mutual funds, REITs, limited partnerships and others may provide return of capital (ROC) distributions that are not a taxable receipt. High-quality bonds trading at a discount provide income and a more favourably-taxed capital gains component.
Other tools may help to defer tax, such as an individual pension plan (IPP) to allow business owners/executives tax-deferred contributions to build retirement income. Small business owners may consider using an estate freeze when succession planning to lock in the tax liability at death based on today’s business value.
These are just a handful of ideas that may help to improve tax efficiency. For a comprehensive discussion, please call the office.
Reminder: Tax Treatment of GICs
With increased interest in Guaranteed Investment Certificates (GICs), remember that the associated tax liability must b¬e reported on an annual basis for non-registered accounts. Many GICs are locked-in, meaning you can’t cash them in until their maturity date. Yet, even if a GIC matures in a future tax year and interest has not yet been paid, the amount that has accrued in the tax year must be reported on a tax return. A T5 slip will be issued for amounts of $50 or more.
.png)
