Individual investment goals may be short term or long term. They may be specific – such as saving for a house, a child's education, or retirement - or they may be general. What they have in common is accumulating wealth. As your wealth accumulates, being a tax-savvy investor can help to increase the after-tax return on your investments.
Through the case study in this article, we look at how Canadian income taxes can affect how an individual with marketable security investments can minimize the impact of taxes on investment growth. The Canadian tax system does not treat all investment income equally; for individuals, interest income is taxed at a higher rate than dividends from Canadian corporations, and both of these have higher tax rates than capital gains. This is true across all of the provinces and territories. It is also true that investing in tax sheltered vehicles such as registered retirement savings plans (RRSPs), Registered retirement income funds (RRIFs) or tax-free savings accounts (TFSAs) affects the after-tax return of investment income.
This article will focus on investments in marketable securities, and not private companies or real estate investment. Investment in private companies or real property is restricted or not allowed in most registered plans.
Case Study
Sam and Pat, a married couple living in Canada, are reviewing their investment portfolios prior to visiting their investment counsellor. Sam has recently received an inheritance and they want to invest that money for their retirement. With the new investment funds, they want to review all of their current and proposed investments as part of the meeting.
Both Sam and Pat are employees; neither owns their own business. They live and work in Ontario. Pat has an employer-matched money purchase Registered Pension Plan (RPP). Every year she contributes the maximum amount that she can to this pension plan. Pat also has a TFSA, and has an RRSP to which she made contributions before she started working for her current employer. Sam's main savings are in an RRSP as his employer does not have a pension plan. He and Pat have not made full RRSP and TFSA contributions. In the current year, both Sam and Pat have employment income in excess of $220,000 per year, and therefore any additional investment income will be taxed at the highest Ontario tax rates.
With this inheritance, Sam and Pat will have enough money to maximize their RRSPs and TFSAs and to invest outside of their registered accounts. They have heard that there can be tax savings depending on how investments are held and want to know more about this before deciding where to invest this inheritance.
Sam and Pat's question
To learn more about tax efficient investing in marketable securities, Sam and Pat asked us, their trusted BDO advisors, for some more information.
BDO's answer
In answering this question, we will first look at how different investments are taxed outside of registered plans, and how that taxation changes when the investments are held within registered plans. Keep in mind that there are many variables to be taken into account besides tax when trying to make investment decisions. These variables include investment goals, risk tolerance, investment time-frame and anticipated income levels in retirement. We'll then provide some general rules of thumb. For non-registered investments, it is assumed that Sam will own these investments himself.
Investing in marketable securities can yield interest, dividends and capital gains. Where the investments are made in Canadian securities, each of these forms of investment return will be taxed differently. (We'll talk about investments in foreign securities later in this article.) The tax rates used in this article assume top marginal tax rates in Ontario, assuming that the rates in effect are the same as they were in 2019.
Interest income earned from Canadian securities is not subject to special rates of taxation. It is taxed as “ordinary income” at the same rate as employment or business income. Because Sam has high-rate employment income, any investment income from non-registered accounts will be taxed at the top rate of 53.53%.
The taxation of dividends from Canadian companies has two components. The first is that the dividend is “grossed-up” for tax purposes. This means that an amount more than the actual dividend received is added to taxable income. However, a dividend tax credit is also granted, which reduces the overall rate of tax on the dividend. Most Canadian marketable securities pay “eligible dividends”. In Ontario, the combined effect of the dividend gross-up and tax credit results in a top tax rate of 39.34%. For those not in the top tax bracket, the rate can be significantly lower.
Only 50% of capital gains are taxed, so the effective tax rate on capital gains in Ontario, at the top rate, is 26.77%. Any equity investment has the potential for a capital gain or a capital loss. However, some investors specifically buy growth investments that have low income yields with a goal of earning a substantial capital gain as a long-term hold. Capital gains realized in a non-registered account can be offset by capital losses that are also realized in a non-registered account, provided the capital loss occurs no more than 3 years after the gain is realized. However, capital losses in a registered account (an RRSP or RRIF) cannot be used to offset capital gains realized in a non-registered account.
Capital gains are only taxed when they are realized (that is, when you sell your investment). If you invest outside of your RRSP in stocks that you expect to sell in the short-term, paying tax on the capital gains upon disposition will reduce the funds you have to invest. Therefore, from a tax perspective it makes sense to hold stocks you intend to sell in the short-term (short-term holds) in your RRSP, where the tax on capital gains will be deferred, and to hold stocks you intend to hold long-term (long-term holds) outside of your RRSP.
Keep in mind that short-term holds are usually riskier. This may conflict with your objective to have stable investments in your RRSP. In addition, if you incur losses on investments held in your RRSP, the losses will not be tax deductible — they will reduce the size of the RRSP available to you in your retirement.
The income earned in an RRSP will be taxed when funds are withdrawn from the RRSP, or from the related RRIF. Income and gains earned in the RRSP lose their character as interest, dividends or capital gains income. When this income is taxed, it is taxed as ordinary income – i.e. at the same rate as employment income or interest income. However, many people have a lower taxable income in retirement, which means that the income coming out of the RRSP could be taxed at a lower rate than if it were held in a non-registered account and taxed when earned. In addition, the fact that income is not taxed within the RRSP means that investment income can grow without tax. These two advantages will reduce the effect of the loss of favourable capital gains or dividend tax rates.
Investment income, including gains, earned in a TFSA is never taxed. So, any type of investment income or gains earned in a TFSA will be sheltered from Canadian tax.
Foreign investments can be an important part of a diverse investment strategy. If you choose to invest directly in foreign investments, rather than through a Canadian fund that invests in foreign securities, there are additional considerations.
For example, suppose you own some shares of a dividend-paying U.S. public company in your investment portfolio. The dividends are subject to a 15% withholding tax. If you held these in a non-registered account, the dividends would be taxed as ordinary income (not as dividends). However, you should get credit against your Canadian tax for the 15% withholding tax so that the U.S. withholding tax will not generally be an additional cost to you.
If you hold that same U.S. stock in your RRSP, there is a provision in the Canada-U.S. tax treaty that exempts registered retirement plans from the withholding tax. So again, there is no net tax cost due to withholding tax. This exemption will also apply if an RRSP is converted to a Registered Retirement Income Fund (RRIF).
This same principle does not apply to TFSAs. This means that if the U.S. stock you hold in your TFSA pays a $100 dividend, you will only receive $85. You will not be able to claim a credit for the $15 U.S. withholding tax, and therefore, the income earned on holding this investment in a TFSA is not entirely tax free.
Currently, there is no U.S. withholding tax on portfolio interest payments from the U.S. to Canada, so the same issue should not arise with interest-bearing marketable securities.
Another factor to consider is the requirement to report certain foreign property holdings to the Canada Revenue Agency (CRA) on form T1135. If the cost of all of the foreign securities, plus any other reportable foreign assets that you own, is more than $100,000 (CDN), then certain information pertaining to the foreign assets must be reported for that year. However, if the foreign securities are held in an RRSP, RRIF or TFSA, this reporting requirement does not apply. There is a penalty of $25 per day for a maximum of 100 days if form T1135 is not filed by the tax-return due date. The CRA regularly assesses such penalties.
Analysis
Until now, Sam and Pat have not had enough money to be worried about which investments to hold outside of a registered plan and which to hold inside. However, with the inheritance, their goal from a tax perspective will be to allocate investments to different accounts to reduce their overall tax exposure. With the above noted tax consequences in mind, here are some rules of thumb. It is important to note that these rules are generalizations and specific advice should be obtained once their investment goals are set.
RRSPs vs. non-registered accounts
- Investments that produce interest income are well suited for RRSPs. This income does not benefit from a preferential tax rate, so no tax advantage will be lost if this type of investment is held in an RRSP and a tax deferral is gained. Similarly, it makes sense to hold investments in stock of U.S. corporations that pay dividends in an RRSP as withholding tax will not apply.
- For equity investments that will produce capital gains and/or dividends, it makes sense to hold these investments outside of an RRSP when compared with investments that produce interest income.
- In terms of long-term versus short-term investments, it may make sense to hold long-term investments outside of RRSPs when compared with short-term holds. For long-term investments with low income yields, tax may not arise until the asset is sold, and therefore, the tax deferral provided by an RRSP may not be needed.
TFSAs
When it comes to TFSAs, there are two common schools of thought. If you are prepared to take risks with your investments, a TFSA may be the best place to hold high-risk investments that could result in large gains. The reason is that if the investment is sold later for a large gain, then the gain will not be taxed and the TFSA can be used at that point to buy a larger volume of income producing investments. So, earning a large gain increases the value of the TFSA as a tax shelter.
For those who have a conservative investment philosophy, it is better to hold interest producing investments in a TFSA while holding investments that produce Canadian dividend income outside of a TFSA. And, as discussed previously, it is better to hold U.S. investments in an RRSP if U.S. withholding tax applies.
Other considerations
Once a portfolio has been established, Sam will need to be cautious about moving investments from one type of account to another. There are rules to prevent “swapping” investments between registered and non-registered accounts. However, it may be possible to sell an asset in one account and buy the same asset in another account with reduced commissions depending on the investment advisor. Sam should also keep in mind that our tax rules prevent the triggering of capital losses where an investment is disposed of in one of their accounts and acquired in another account within 30 days.
A final point to remember, is that because the inheritance is Sam's, they will need to be aware of the income attribution rules if Sam wants to gift funds to Pat to invest. For non-registered accounts, any amounts that were gifted from Sam and then invested by Pat will create income that is taxable to Sam and not Pat. However, there is an exception for this rule if Sam were to contribute to a spousal RRSP or gift funds that Pat then invested in her TFSA. If it made sense, Sam could use some of his RRSP contribution room to contribute to a spousal RRSP for Pat. As long as the funds are not withdrawn from the RRSP in the contribution year or either of the next two years, the RRSP withdrawal will be taxed as Pat's taxable income. The attribution rules do not apply to income earned in a TFSA, but will apply if assets are transferred from the TFSA and invested outside of the TFSA.
For more information and specific advice, please contact your BDO advisor.
The information in this publication is current as of December 12, 2019.
This publication has been carefully prepared, but it has been written in general terms and should be seen as broad guidance only. The publication cannot be relied upon to cover specific situations and you should not act, or refrain from acting, upon the information contained therein without obtaining specific professional advice. Please contact BDO Canada LLP to discuss these matters in the context of your particular circumstances. BDO Canada LLP, its partners, employees and agents do not accept or assume any liability or duty of care for any loss arising from any action taken or not taken by anyone in reliance on the information in this publication or for any decision based on it.