By Miles Clyne
There are four essentials to maximize investment results. Each piece is critical. They are:
· When you start
· How much you contribute
· The rate of return you get
· Tax efficiency
TAX EFFICIENCY is the focus of this article. Given you hopefully have your 2015 taxes behind you, now is the time to be thinking about your 2016 and beyond taxes.
There is a lot of talk that would suggest investors should focus on dividends. Consider the following:
Tax Free Savings Accounts are subject to withholding tax on dividends by the source country. Canadian mutual funds or Canadian listed exchange traded funds (ETFs) that own foreign stocks are also subject to withholding tax on dividends earned in an RRSP.
US stocks trading on a US exchange are not subject to withholding tax on dividends when held in an RRSP, but they are in a TFSA. So put the right stocks in the right accounts. And when you think about diversification, sometimes there isn’t anything wrong from a tax perspective staying focused on quality Canadian stocks. Less tax means more potential, regardless of how limited that potential is.
In non-registered accounts, owning investments that generate capital gains is more efficient than dividends in most cases and, Canadian dividends are more tax efficient than foreign dividends and interest income that bonds and GICs produce. Your tax bracket plays a role with the amount dividends are taxed, they are more beneficial for people in lower tax brackets.
Real estate investment trusts (REITs) and limited partnerships (LPs) can pay income in a variety of forms. Dividends can be one form and they are taxed as previously discussed. Some of the income can be return of capital, where the income isn’t immediately taxed. But it lowers the cost of your investments so you ultimately pay more in capital gains. It’s usually a good thing to defer tax.
In Summary – Asset Location Preferences:
Non-Registered = Canadian dividend paying stocks.
TFSAs = Canadian dividend paying stocks and Canadian REITs. .
RRSPs = U.S. dividend paying stocks and U.S.-listed ETFs.
Maximizing long-term tax efficiency may be why having all your money in RRSPs may not be the best after-tax solution for many. When you convert your RRSP to a RIF and begin withdrawals, the tax man takes a bite out of every dollar. The tax liability on your RIF is at your marginal tax rate. This can be substantial depending on how successful you have been in growing your investments and the combination of your other pensions.
Conventional wisdom suggests keeping interest generating investments like bonds and GICs in RRSPs as the income isn’t taxed. If you are in a 30% marginal tax bracket, I wonder how investors will feel when they realize the money they’d earned two or three percent on for years gets taxes at 30%? This is a primary reason in my personal RRSP I focus on growing the market value VS. focusing on only “safe” investments.
At the end of the day, ignoring tax can mean you have to save longer and or save more to meet your income needs. Get tax savvy or know someone who is. This is low hanging fruit that should be picked.