Reduce tax brackets by organizing where you hold investments

Not all income is created equal

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minimize taxes

(Getty Images / Peter Dazeley)

Nobody likes to pay taxes.

But while they are inevitable, you can minimize the amount you pay.

Brent Vandermeer, a portfolio manager with HollisWealth, says to build a tax efficient portfolio you need to pay attention to what you hold and where it’s held.

“A lot of people view each of their own accounts that they have set up as distinct little buckets that they manage,” he said.

“From a tax efficiency point of view that actually negates some of the benefit of having certain kinds of investments in more tax efficient accounts.”

That’s because in the eyes of the Canada Revenue Agency, not all investment income is created equal.

Under the tax rules, interest income from investments like savings accounts, GICs and bonds are fully taxable at your marginal tax rate, while dividends benefit from the dividend tax credit that helps reduce the amount of tax you owe.

And only half of any capital gain is included when calculating your taxes.

Vandermeer says those differences mean you need to pay attention to where your investments are held, whether it is your RRSP, tax-free savings account or other non-registered account.

In an RRSP account, all of the investment income grows tax free inside the account. However, when the money is withdrawn it is treated as regular income and fully taxed regardless of how it was earned inside the account. You don’t benefit from preferential treatment of dividends or capital gains.

That compares with TFSAs in which none of the money withdrawn from an account is taxed, no matter how it was earned — interest, dividend or capital gains.

Vandermeer says to take advantage of characteristics of each account you need to take a look at the big picture rather than treat each individual account separately with its own asset mix.

“You want to look at the overall household as one pot of money and then in each account we’ll put specific investments into specific accounts,” he said.

“We’ll take the investments that we think are better positioned to be more tax efficient and put them in those accounts and put the more inefficient investments in the tax-sheltered accounts.”

After you’ve maxed out your TFSA and RRSP limits, there are certain classes of investments that can help defer the tax burden for your non-registered accounts, said Peter Bowen, vice-president of tax research and solutions at Fidelity Investments.

Bowen said corporate class mutual funds allow investors to rebalance or change their investments without any immediate tax consequences, deferring any capital gains tax to when the corporate class shares are sold.

Meanwhile, he said investors who need an income stream from their investments can defer capital gains taxes but still create a monthly cash flow by using a Tax-Smart Withdrawal Program or T-SWP.

Bowen noted you’ll still pay the capital gains tax eventually, but it will be pushed further into the future than if you were selling a portion of your investments each month.

“If we can keep it in our investment accounts, rather than having CRA have our money, we can enhance our after-tax returns over the long term,” he said.

But both Bowen and Vandermeer stressed that while the tax benefits or consequences of an investment need to be considered, any decision needs to make sense for your own risk tolerance and financial plan.

“If we can keep more money in your pocket versus the government’s, that’s part of the return calculation,” Vandermeer said.

“But we always remind people that it should never drive the bus. It should never be put ahead of proper portfolio design, risk tolerance assessment and all of that.”

2 comments on “Reduce tax brackets by organizing where you hold investments

  1. Don’t believe it. The idea that “In an RRSP account, income grows tax free, however when the money is withdrawn it is fully taxed is false. The taxes paid on withdrawal are an allocation of capital, not a tax on profits. Profits in a RRSP are never taxed. How does he explain the accepted fact that outcomes of an RRPS and TFSA are always exactly equal (when tax rates don’t change between cont and w/d)??? Because they both shelter profits permanently in exactly the same way.

    Please watch the 2nd video at https://www.youtube.com/channel/UCYf70uCj5q4GRWYC0wVtdxg to see how this happens and why this claim is false.The third of the series cover the remaining benefits and shows how they are simply added to the main benefit of permanent profit sheltering, without changing it.

    And all the stuff about tax rates on different types of income is also misleading. Your objective is not to save tax%. It is to save tax$. The asset’s rate of return is waaaaaay more important than the tax% for determining the compounding value of these account’s tax-sheltering. Please read http://www.retailinvestor.org/rrsp.html#taxfree

    Reply

  2. Where can I find information on a Tax-Smart Withdrawal Program? Thank you!

    Reply

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