Taxes are often the inevitable consequence of success. When your investments pay off, you usually have to pay out more taxes. Or do you? If some of your income comes from investments, there are tax-wise investing strategies you can use to successfully reduce your tax bite. Here are a few simple ways to structure a tax-efficient investment portfolio.
You can earn investment income in three ways – and each is taxed differently.
1. Interest - Fixed income investments such as money market mutual funds, bonds and bond funds, Guaranteed Investment Certificates (GICs) and term deposits pay interest. Interest income is fully taxable – if you are in a 40% tax bracket, 40 cents of every dollar of interest income will go to the government.
2. Dividends - Income from stocks or mutual funds that invest in stocks is taxed more favourably than interest income, because most dividends you receive from Canadian corporations qualify for a Dividend Tax Credit that can reduce your tax bite.
3. Capital gains - Capital gains get the biggest break, especially in the higher tax brackets. Only 50% of a capital gain is included in income for tax purposes.* So if you realize a capital gain of $100, only $50 of it may be subject to tax. And you can offset taxable capital gains against allowable capital losses.
Key tax-saving tactics
Invest in tax-sheltered registered plans. Most Canadians won't find a better tax-deferral vehicle than a Retirement Savings Plan (RSP). Your contributions (within limits) are fully deductible from income and all earnings in the plan accumulate on a tax-deferred basis until you withdraw funds, or begin to receive a retirement income.
Invest tax-intelligently. The government limits total RSP contributions so most investors need a portfolio of non-registered investments to reach their savings goals. These are taxed at a rate that depends on the source of income. When you invest intelligently, you can benefit from tax deferrals by:
- Buying and holding investments: Taxes on capital gains are usually not payable until the gains are realized so you can defer or even reduce taxes by choosing to sell these investments when your marginal tax rate is lower.
- Investing in tax-advantaged mutual funds: This type of fund structure allows you to take a profit on a fund by moving assets freely among the structure's share classes while deferring capital gains.
Split income. By using a spousal RRSP to split income between a higher income earner and a lower income-earning spouse, the overall tax bite is reduced. There can also be tax-saving benefits to making a loan at the prescribed interest rate to a lower-earning spouse for investment purposes, transferring assets or money to a child in investments that appreciate in value, or establishing a Registered Education Savings Plan (RESP) for each child.
Split expenses. If one spouse earns more, and is in a higher marginal tax bracket, that spouse should pay for daily living expenses while the lower income spouse invests more. That way, any income generated from those investments is taxed at lower rates than if the investments had been made by the higher earning spouse.
Use these and other tax reduction strategies to make your investment portfolio as tax-efficient as possible. A financial advisor can help make sure your tax bill is reduced through a tax plan that is a perfect fit to help you reach your overall goals.
