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Minimizing Income Taxes on Your Investments

By Monty Spivak
Posted May 15, 2011 in Business
At this time of year, we are all communicating with the Canada Revenue Agency (CRA) about additional taxes to be paid or anticipated refunds. Now that you have seen your total income tax bill, the question is how to plan your investments to keep as much of your income as possible.
Everyone should become familiar with the basic tax-reducing strategy. It is widely available on many investment company websites:
1. Interest-generating income should be in RRSPs (Registered Retirement Savings Plans) and TSFAs (Tax Free Savings Accounts).
2. Equity income (dividends and capital gains have preferential taxation treatment) should be held outside of tax-sheltered accounts.
Unfortunately, the investments sites to not provide sufficient detail on one’s actual income tax liabilities, depending upon which investments are held in what accounts; they provide general rules. There are many equity-income types of investments, and many of these do not provide the investor with the same income-tax benefits as the standard, Canadian dividend-paying shares.
Below is a chart of the effective tax rate on different types of income. I used a modest pension income, with only standard deductions, to model the overall tax rates. As you can see, the tax rates substantially differ based on the source of income:
Table comparing Canadian income tax rates on investments
Table comparing Canadian income tax rates on investments
Assumptions used for investment tax rates table
Assumptions used for investment tax rates table
I contacted (Intuit) TurboTax Product Support to ensure that I have not misinterpreted the calculations. They assured me that:
All T-slips/Forms/Worksheets, transfers, calculations etc. are also based on guidelines provided by CRA… If you have entered all your information correctly, you will get correct output. (Note: hopefully, I input the correct information)
Income trusts (typically REITs, but include certain Closed-End Funds and a few remaining business trusts) pose a unique opportunity because they typically distribute a “Return Of Capital” (ROC). This is tax-advantageous, as it is not currently taxable. It reduces your adjusted cost base (ACB), so will increase your capital gains at the time that you sell your units. You must keep a record of your ACB adjustments so the correct capital gain (or loss) can be reported when the income trust is sold. The record keeping is a nuisance, but the tax benefits can create substantial savings over the years.
I have excluded illiquid, very-high risk, and tax-subsidized “special cases” from this analysis. I am not proposing that you invest or not invest in these to achieve your goals. Rather, I suggest that these are outside of what I am planning as part of my retirement portfolio. The exclusions are special-case tax credits:
1. Flow-through Shares (FTS) is mainly for junior mining, oil and gas shares. The FTS mechanism allows the issuer corporation to transfer the resource expenses to the investor. I view this as very high risk, and the primary purpose seems to be the creation of a tax credit (and appears to be our government’s mechanism to encourage support for the financing of these high-risk ventures), rather than to generate a stream of investment/retirement income.
2. Labour-Sponsored Venture Capital Funds (LSVCs) provide capital to small Canadian businesses. The federal government offers a tax credit of 15% to investors. Provincial governments often add additional tax savings. Complaints include the very-high fees, illiquidity, and unprofitability of some of these investments.
3. Canadian Film or Video Production Tax Credit (often combined with Provincial tax credits) is, again, a tax credit scheme, rather than a moderate-risk investment vehicle for retirement.
There is the risk of loss with most investments. The spectrum ranges from very-low risk for Government of Canada securities, and those guaranteed by the federal government, to the high-risk corporate stocks and bonds. I am not an investment advisor, and recommend that you consult with one before making your investment decisions. Here are a few examples (for disclosure purposes, I do not currently hold any of the specific securities identified with tickers):
Example investments for tax rates
Example investments for tax rates
Depending upon your investment objectives, you would choose stocks, funds, bonds, or other securities. Part of this decision should be where to hold the investment-tax-sheltered, or in an investment account outside of a tax-shelter. As part of optimizing your return, you should consider targeting a lower tax liability on your investment income (in retirement). Of course, each person’s circumstance is different, but here are a few general ideas to reduce your investment income taxation:
1. For income-oriented securities, buy Canadian REITs and Canadian dividend-paying stocks outside of tax shelters.
2. If you are buying securities for capital gains (such as gold bullion, or other investments which are held for capital appreciation), also keep these outside of your tax shelters.
3. Limited Partnerships are taxed as salaries – the highest form of taxation. Hold these in tax-sheltered accounts.
4. Foreign dividends and interest income attract the same (high) taxation rate. Hold these in your tax-sheltered accounts (particularly for USA and UK investments).
Foreign income merits a special mention.
1. Only certain categories of foreign holdings are permitted in your RRSPs and TSFAs, so be careful when choosing these. For example, Over-The-Counter (OTC, New York) traded securities do not qualify.
2. If you are holding foreign dividend-paying stocks outside of your tax shelters, then you should seek those which will provide you a premium return over the tax-preferred, Canadian securities. For example, in the last scenario of the table, above, with an investment income of $72,000 of foreign dividends, you will be taxed at 26%, whereas the same Canadian dividends will provide you an overall tax rate at 12%. You should plan the total return of your foreign investment (which includes capital appreciation plus distributions) to compensate for the tax differential.
3. For currency and geographic diversification purposes, you may choose to accept lower after-tax returns in exchange for risk-mitigation.
4. Certain jurisdictions have higher income tax rates than Canada (e.g., many European countries). When the foreign tax rates are higher than the respective Canadian taxes, then it makes more sense to keep these investments outside of your registered plans, as CRA credits you for the foreign taxes paid. One recent learning is that ADRs (global securities traded in New York) are taxed/withheld at the US withholding rates, not the Canadian withholding rates on the foreign non-US holdings.
5. I have added this last point, which is a recent learning. For US Master Limited Partnerships (MLPs), tax is withheld at source regardless of account type. Therefore, you will pay 35% withholding tax for MLPs in your RRSP. In order to recover these punitive taxes, you should hold these outside of your registered plans (in your taxable account).
The bottom line is that you can improve your after-tax income by carefully managing where you hold your various types of investments. The old adage “It's not what you make, it's what you spend” applies; positioning your investments in a tax-advantaged way can reduce your spending on income taxes.

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