Do you know the real rate of return on your investments? Generally, Canadians measure the success of their investments based only on the rate of return. While this provides a good snapshot of whether an investment is doing well or not, it is not the only criterion for a true picture of success. A good portfolio is based not only on the return, but also by the tax implications of the investments.
Investors can optimize their real rate of return by utilizing effective asset location strategies to reduce tax exposure. Carefully dividing your investments between registered and non-registered portfolios will help to maximize your overall return. Keep in mind, investment income inside your Retirement Savings Plans (RSP) is tax postponed and is not taxable at all in a Tax Free Savings (TFSA). Everything outside of these investments will have an income tax implication you need to be aware of.
Understanding how your investment income is taxed goes a long way in determining where to invest your money. Investment income falls into three main types. Each has different tax treatment when held outside your registered investments:
Interest income has the highest tax rate of the three regardless of your income. Whether you receive the interest or let it compound, it is fully taxable.
Capital gains income is also taxed favourably as only 50 percent of the gain is included in income for tax purposes.
An Ontario resident, for example, whose income falls into the highest marginal income tax bracket would pay over 46 percent tax on interest income, over 26 percent on eligible dividends , and over 23 percent on capital gains if these investments are in a non-registered account. Tax rates vary by province.
If these three incomes are within a registered portfolio such as a Registered Retirement Savings Plan (RRSP) or a Registered Retirement Income Fund (RRIF), the taxes are postponed until you begin to make withdrawals and are then fully taxed at your marginal tax rate.
It would be great to have your entire portfolio in an RSP or TFSA, but each has certain contribution limits. If your portfolio includes fixed income securities, you could take maximum advantage of keeping these within an RSP or TFSA for tax shelter purposes. If you have reached the limits of your tax sheltered investments, any equity investments that produce tax-preferred income (capital gains and dividends) would be suitable to include in a non-registered account.
Tax implications should not be your sole motivating factor when choosing your investments. Try to gear your investments so they are suitable for your specific situation and risk tolerance, then focus on the best tax efficiency. – M Dumond