Would you rather make six per cent or five per cent on your investments
Believe it or not, some investment managers and self-directed investors would rather earn five per cent. The reason is that they don't pay any attention to taxes.
By way of example, it is possible for some individuals to make a 10 per cent return on their investments, but they then have to pay five per cent in taxes, leaving just five per cent in their pocket. At the same time, someone can earn seven per cent, but only have to pay one per cent in taxes, leaving six per cent in their pocket. Many people focus only on the before tax-return when its the after tax return that really matters. Focusing on before-tax returns is the proverbial not seeing the forest for the trees.
All of this gets us to the issue of how to be a tax efficient investor.
If you have all of your investments in RRSPs, RRIFs or TFSAs, then investment taxes are not a concern for you. However, most higher-net-worth Canadians have meaningful money that is not sheltered from tax. This also can become an issue rather suddenly for many investors if they receive a sizable inheritance, receive the commuted value from their pension or sell their house.
For those of you for whom taxes on investments are an important issue, here are five ways to lower your investment taxes:
1. Buy stocks with no income – and don't sell them
With all of the focus on income and dividend yields, we sometimes forget one of the reasons that some companies pay no dividend: They actually believe that reinvesting in the company is more valuable than giving the cash to shareholders. The tax benefit is that you have no income to report each year. The best Canadian example would be CGI Group. The stock pays no dividend, but the share price is up over 200 per cent over the last five years. If you bought and held this stock, you would have reported $0 in investment income — even if you had $1 million in the stock.
In the U.S., examples would be Chipotle Mexican Grill, which as a zero per cent dividend, and is up 311 per cent over five years. Another name some might know is Under Armour. Another stock with a zero per cent dividend, it's up more than 700 per cent over five years.
Of course, when you actually sell the stock, you will face capital gains taxes, but you can defer those for many years, and even then, the tax rate will be half that of your interest income in any year.
The downside is that if the stock is not doing well, you don't even have a regular dividend to keep you company.
2. Focus on capital gains and qualified dividends in taxable accounts
The top marginal tax rate in Ontario starts with income over $220,000. Above that income, interest is taxed at 49.5 per cent, capital gains at half that rate (24.8 per cent) and eligible dividends (generally from publicly traded companies) at 33.8 per cent. In Alberta, at roughly $138,000 the marginal tax rate is 40 per cent on interest, 20 per cent on dividends and 20 per cent on capital gains. Even though Alberta rates are much lower today, there are changes coming at the top end that will likely narrow the gap between Alberta and Ontario tax rates.
Using the Ontario example, interest from savings accounts, bonds and GICs would be taxed at 49.5 per cent; dividends from eligible Canadian companies (stocks and preferred shares) would be taxed at 33.8 per cent; and dividends from non-Canadian companies would be taxed at 49.5 per cent.
Capital gains are treated the same whether they are from a Canadian or foreign investment. So it is generally a good idea to try not to hold too any interest-producing or dividend-paying stocks from foreign companies in your taxable account.
This past year, this strategy would have hurt if you held many preferred shares instead of bonds to take advantage of the tax benefit, as preferred shares meaningfully underperformed bonds. Next year, holding preferred shares may be a winner for tax and investment reasons.
This strategy can also lead someone to take on more investment risk, as it leads you away from low risk, low volatility investments.
Overall though, this strategy, if done well, can result in a portfolio with the exact same holdings, but a lower tax bill.
3. Invest taxable money where it won't be taxed
Just because you have no more room in your RRSP or TFSA doesn't mean you have to invest in a taxable account. The best tax shelter in Canada is a principal residence. Why not buy a bigger house or move to a nicer neighbourhood
I know that there may be many practical reasons not to do so, but from a pure tax focus, investing more in a principal residence allows for complete tax-free growth (except for the higher annual real estate tax bill).
Another option is to purchase a universal life Insurance policy (or use an existing policy), and invest extra money within the policy. This will grow tax sheltered up to certain specified tax limits.
These may not be the most flexible or liquid investment strategies, but they will lower your annual tax bill.
4. Use corporate class funds to receive better tax treatment
As mentioned above, interest income is taxed fully, but what if you could do some financial engineering to receive investment returns that moved like bonds, but were taxed like dividends or capital gains Better yet, have them taxed as something called return of capital – which is effectively getting your own money back and therefore not being taxed at all (although it will ultimately increase your capital gains when you sell).
It turns out that you can do this. While some rules came into play a few years ago that reduced the ability to change the nature of investment income, several opportunities still exist.
Corporate class mutual funds use some smart investment strategies that help to not only allow you to invest in something like a bond fund, but have income treated as Canadian dividends or capital gains. In addition, investments in a corporate class fund can usually allow you to defer capital gains taxes until you exit your funds from the entire fund family. This means that you can sell Company A Bond fund and buy Company A Stock fund, and not have to pay capital gains taxes if you made a gain on your Bond fund purchase.
Of course, all is not perfect in this approach. The downside is that you need to own mutual funds, and corporate class funds generally have higher fees than regular funds. As a result, you might only want to use corporate class funds if you are in the top tax bracket, and only for a specific segment of your investments that would otherwise be taxed higher.
5. Spousal loans at one per cent
If one member of a couple is in the top tax bracket and the other member is not working, and you have meaningful non-registered investment assets, then you have the ideal scenario for a spousal loan.
The idea is that the high-income spouse “lends” the low-income spouse money and that money is used to purchase investments that are held in the low-income spouses' name. In Ontario that could mean the difference between paying 49.5 cents on $1 of investment income in the hands of one spouse, and 20 cents on the dollar in the hands of the other. Of interest, the strategy makes less sense in Alberta because the gap in tax rate from high income to low income is much smaller (40 per cent to 25 per cent).
In order to make this happen properly, the low-income spouse must pay interest each year to the high-income spouse at a rate of just one per cent (using the current rate provided by CRA). The great news is that this rate will hold for as long as the loan is in place. In other words, this low one per cent rate could last for the rest of your life. A higher rate makes this strategy more expensive, because the loan interest is treated as income in the hands of the higher income spouse (and as an expense for the lower income spouse).
As you can see, each of these tax driven strategies have an obvious benefit, but they usually have some downside as well. From my perspective, the key is to understand the options and perhaps take advantage of a few that might add value to your particular situation. To simply ignore the tax side of the investment equation is just bad investment and wealth management.