Most investors review their portfolios at the end of the year, but the brunt of those decisions are felt the most as we near the tax-filing deadline.
For many, tax season is a big wake up call, especially for those who have to fork over a portion of their capital gains and dividends to the tax collectors. Depending on how well your investments performed the previous year, the tax bill could be huge.
Unfortunately, investors tend to be more focused on their returns than mitigating the tax hit. “That’s a problem,” says Russ MacKay, an associate portfolio manager with Calgary investment firm McLean & Partners. Chasing returns is always nice, he says, but at the end of the day you need to check to see if the gains you earned on your investments are being eroded by taxes. A smart investor knows there are ways to get good returns and pay less to the Canada Revenue Agency.
Capital gains taxes
The first step is to understand how different investments are taxed. In most parts of the country, capital gains—the amount of money you make when you sell a stock—get the best tax treatment. Capital gains are taxed at your income tax rate, but only half the gain is subject to tax. So a top earner living in Ontario would pay just 23.2% on the money they made from selling a stock.
Canadian dividends also receive preferable tax treatment. How much you have to pay on those dividends depends on the province and your tax bracket. In Ontario, the highest income earner would pay 29.54% tax on payments; in Alberta someone in the top bracket would pay 19.5%.
Jason Safer, a Toronto-based tax leader with PricewaterhouseCoopers, says dividends and capital gains should be held outside an RRSP so you can take advantage of the tax-efficient treatment.
From a tax perspective, the best type of investment you can own is a growth stock that doesn’t pay a dividend, says Safer. “That’s because there’s no annual income stream and you’ll only be taxed when you sell the investment,” he explains.
Unfortunately, foreign dividends don’t get any special tax treatment. In fact, countries hold back 15% of those payments, so you could wind up with less money than you might expect. It’s not all bad news—if you hold U.S. dividends in an RRSP, you will get the entire dividend.
And, if you own any non-Canadian dividend paying company outside of a registered account then you can get a tax deduction for the amount that’s been withheld. However, if you hold foreign dividend stocks inside a TFSA, you won’t get the credit nor will you get the withholding tax back.
Patti Shannon, vice-president and portfolio manager with Leith Wheeler Investment Counsel in Calgary, says U.S. dividends should always be held inside an RRSP to ensure you can get the full payout. On the other hand, she continues, dividends from other foreign corporations should be kept outside a registered account in order to get that tax credit.
Bond payments are taxed as straight income, which means if you’re in the top bracket in Ontario, you’ll have to pay about 46% tax. It’s the least tax efficient investment around.
According to Shannon, bonds should never be held outside an RRSP. Since they receive no special tax advantage, it’s best to let the payments grow inside an RRSP—or a TFSA—tax-free, she says.
Investors also need to think about selling stock in order to receive capital losses. Losses are calculated the exact same way as gains, except your receive a tax deduction on that loss. A capital loss can then be used to offset a capital gain. So, if you sold a stock and made $1,000, you’d owe the government (again, in Ontario and in the highest tax bracket) about $231. If you lost $1,000 on a stock, you’d get a deduction for that same amount. The loss and gain would cancel each other out, so you wouldn’t have to pay a dime.
MacKay doesn’t advocate selling a stock just to get the loss, but, if a company really is a dud, then why not get some benefit from the poor performer? “Utilize those losses to offset big gains,” he says. If you don’t have any gains to offset that year, you should still sell—losses can be carried back three years or carried forward indefinitely. So if you sold a bunch of stock in, say, 2008 and expect to realize gains this year, then use those losses so you can pay less tax.
Most of this has to be done before December 31, but with tax on the minds of many Canadians, now could be the ideal time to make sure you’ve got a the most tax efficient portfolio possible. “The savings could significant,” says MacKay. “Imagine if you shot an arrow and didn’t know here you were pointing at. You could be in for a big surprise.”