If you had to choose between two investments, one offering returns of 10% and the second offering returns of 8%, which would you choose? This is not a trick question. Most people would choose the 10% investment. However, if the first investment produced an after tax return of 6% while the second investment produced returns after tax of 7%, which would you choose now? No matter what return you make, the real indicator of success is the after tax return.
The old saying goes, “It's not what you make but rather what you keep that counts”. This is crucial in the investment world.
What is tax smart investing?
Tax smart investing is simply being aware and focused on the after tax implications of any investment decision. Tax smart investing is especially important when investing non-RRSP money because any investment earnings are taxed unlike investing money inside an RRSP, where all investment income is tax sheltered.
In the most recent budget, the government introduced Tax-Free Savings Plans (TFSP), which will also shelter the investor from having to pay any tax on investment income but will not provide a tax deduction at the time of deposit. Any withdrawals from the TFSP will not be taxable. The introduction of TFSPs is long overdue, as they will open up many new strategies for tax smart investing but unfortunately, they will not be available until 2009 at the earliest.
What is your after tax return?
The biggest problem in the investment industry today is that all returns are posted as pre-tax returns and not after tax returns. Unfortunately there is very limited information available regarding after tax returns of investments.
Finding after tax returns for investments is tough because it is complicated, individual and not required by law. That being said, it's not impossible. For example, in the mutual fund industry companies like Morningstar offer some limited data on tax efficiency and after tax returns but there are still some inconsistencies in the data. The bottom line is the industry still lacks standards and there is no universally accepted means to posting after tax returns.
Be aware of how investment income is taxed
When most people consider investment opportunities, the focus tends to be on the quality of the investment and its ability to make money. Although selecting good quality investments is important, different investments will appeal to different investors. In my opinion there's little to no consideration given to taxation of investments when selecting investments. Don't fall into this mistake. The starting point to understanding tax efficiency is to learn about how different investments are taxed. There are three basic types of investment income:
- Interest income is the least tax efficient investment income because it is fully taxable at your marginal tax rate. Interest income comes from bank accounts, Guaranteed Investment Certificates (GICs), bonds, and bond funds.
- Capital gains income is taxed more favourably than interest income because only half of the total gain is taxable. Capital gains are taxed only when they are sold or transferred. Until investments are sold for a gain, they are considered unrealized gains and tax is deferred until disposition.
- Dividend income comes from shares of taxable Canadian corporations. Some mutual funds specialize in investing in stocks that pay dividends regularly. Dividend income is now the most tax-preferred type of investment income because of the changes to the dividend tax credit which can translate into significant tax savings over interest income.
In a country like Canada where almost 50% of your income gets taxed, tax smart strategies should always be a priority. When it comes to investing, being smart starts with some basic understanding about how your investments outside the RRSP are taxed.