If you are looking to invest non-RRSP money, it is crucial that you are aware of the implications of tax. The biggest problem in the industry today is that we post pre-tax returns and not after tax returns. Investing and taxes go hand in hand so be sure to understand how different investments are taxed.
Determine your tax rate
The first place to start in determining how much of your investment income is going to go to the government is to look at your marginal tax bracket. The Canadian Income Tax system is based on graduated tax levels. What this boils down to is the higher your total taxable income, the more tax that you will pay (see chart interest income column). You can benefit dramatically if you are able to share less of your growth with the government.
|over $43,953 up to $87,907||22.00%||11.00%||9.63%||12.96%|
|over $87,907 up to $136,270||26.00%||13.00%||15.15%||17.68%|
To see the tax rates for all provinces and territories, download the 2014 Tax rate card
Giving less to the government
As you can also see from the chart different forms of investment income can provide significant tax benefits.
The key is to determine whether other investment income will benefit you. Too often I hear advice has been given to an investor based solely on a tax perspective. As important as this may be, there are may other considerations that must be taken into account like risk, income needs, time horizon, other assets, etc.
Individuals receive preferential treatment on dividends received from Canadian Corporations. Dividends translate into significant tax savings on investments because of a dividend tax credit. In fact, it can mean significant improvements in your after tax return on investment.
Dividend funds can be a very solid alternative to interest income investments.
Capital gains can be created through investments in stocks, real estate or equity mutual funds. The advantage to earning capital gains is only 50% of your gain is taxed. The remaining 50% grows tax-free. Often capital gains investments offer a deferral on income since the tax only applies when there is a sale of the investment. Conservative investors should be aware that more volatile investments typically generate capital gains so invest wisely.
The conservative investor who can accept the income of low interest rates but wishes to find ways to reduce tax may look towards the prescribed annuity. Prescribed annuities have tax deferral benefits because interest is leveled and spread over a period of time. Combined with conservative mutual funds a prescribed annuity can provide less taxes and higher spendable returns.
A newer breed of GIC investments is the index-linked GIC. The index-linked GIC guarantees capital and links your rate of return to a market index or investment (TSX, S&P, etc). The benefits are the peace of mind of knowing that your capital is guaranteed and the higher potential returns than interest rates offer today. However, it important that the investor realizes the growth, even though linked to a “stock market” is classified as interest income. The only saving grace might be that you don't have to pay income tax every year like a GIC or savings bond. Rather, tax is paid at the very end at maturity.
Related article: Create your own index linked GIC
People invest in mutual funds for many reasons; diversification, higher returns, liquidity and professional management. We should not forget that many mutual funds also offer significant tax benefits to investing outside of the RRSP. Many mutual funds can provide tax benefits in the form of dividend income, deferred capital gains, return of capital, and tax sheltered opportunities. Today there is a mutual fund for every purpose and if taxes are your concern there are corporate class mutual funds designed to be more tax efficient.
RRSPs and TFSAs
Remember that investment income inside RRSPs are tax deferred until withdrawal. At that time, the withdrawal is fully taxable. Investment inside the TFSA grow tax free so it's a great place to invest your money. Make sure you fill up your TFSA before investing in non-registered accounts.