Tax Smart Investing – Part 1
We must start with a basic understanding of the different rates at which the different kinds of investment income are taxed in a non-sheltered account, by level of taxable income, as summarized in the following table:
|Kind of income||Under $32,000||$32,000 to $63,000||$63,000 to $64,000||$64,000 To $72,000||$72,000 to $88,000||$88,000 to $104,000||More than $104,000|
|RRSP / RRIF||22.20||31.15||33.70||37.70||39.70||40.70||43.70|
The bracket ranges have been simplified slightly for ease of presentation. The multitude of brackets results from the overlay of federal and provincial tax brackets. These are 2003 rates for BC residents. The analysis for 2004 would not change very much as tax rates for both the federal and BC governments did not change, although each of their bracket ranges changed somewhat (See the Insight Library for a comparison of 2003 and 2004 rates and brackets).
The following is noteworthy:
- At all income levels the capital gains tax rate is precisely one-half of the interest tax rate, simply due to the one-half inclusion rate for capital gains.
- The dividend tax rate, however, is more complicated due to the operation of the dividend tax credit. You will see that at the lowest tax bracket, dividends are barely taxed at all and are taxed significantly lower than capital gains and interest. At the next bracket, the dividend tax rate is very close to the capital gains tax rate. Beyond this, the dividend tax rate runs away from the capital gains tax rate. This point has led to pressure on government to adjust the taxation of dividends, particularly since capital gains tax rates were dropped significantly in the Fall of 2000.
- Foreign dividends are not shown in the table; however, they effectively are taxed as interest.
- The top marginal tax rates are noteworthy, having dropped in recent years, e.g. interest income from over 50% to 43.7%.
- The marginal tax rate jumps significantly from the first to the second bracket but thereafter only in small increments. However, many taxpayers reside in that second bracket!
- Remember that the timing of interest and dividend income taxation is out of the control of the taxpayer because it is driven by the payee, e.g. banks paying interest, companies paying dividends. However, the timing of capital gains taxation may be under the control of the taxpayer by way of choosing when to sell assets. However, this control is partially given over to fund managers when mutual funds are held instead of direct investments.
RRSP / RRIF
The RRSP/RRIF line in the table highlights a few important points for investments held in sheltered accounts:
- The preferential tax treatment for capital gains (i.e. one-half taxed) is foregone.
- The preferential tax treatment for Canadian dividends (i.e. dividend tax credit) is foregone.
- The taxpayer controls the “tax gate” on taxation of all income out of sheltered accounts because there is NO taxation until amounts are withdrawn.
- No foreign taxes are withheld on foreign dividends received within a sheltered account.
Prudent tax management includes, where possible and appropriate:
- Emphasizing interest-paying investments in sheltered accounts and equity investments in non-sheltered accounts.
- Linking future cash requirements to the investments that will be sold to meet those calls.
- Controlling the timing of realizing taxable capital gains in non-sheltered accounts by holding more direct investments and exchange-traded funds.
- Altering the mix of interest-paying and equity investments between a couple, bearing in mind their relative tax situations.
- Bearing in mind one’s tax rate today versus expected future rates.
- Placing certain investment vehicles with unique tax characteristics into sheltered instead of non-sheltered accounts. This includes, for instance, “synthetic” financial instruments which legally circumvent the foreign content restrictions by the way that those foreign investments are held. The downside to these investments is that all income is taxed effectively as interest income, thus losing any preferential treatment as capital gains or dividends in a non-sheltered account. As you can see in the table, this downside is avoided in an RRSP or RRIF where all income is taxed the same anyway. For Trivest investors, this includes for instance, the international exchange-traded funds “XIN” and “XSP”. “Index-linked GICs” are another example of this kind of investment (visit the Foresight Library on our website).
- Holding compounding interest-bearing investments, like strip bonds, in sheltered accounts instead of non-sheltered accounts, to simplify annual tax preparation and match cash inflows to tax outflows.
- Holding investments with cash inflow from tax-free return of capital in non-sheltered accounts. This includes many income trust units which are able to distribute their capital cost allowance as tax-free return of capital. Upon sale, this potentially converts taxation from interest income tax rates to more favourable capital gains tax rates.
In closing, you will see that there are various layers of complexity to prudent and competent tax smart investing. Make sure that your portfolio is tax smart!