Three ways to help minimize your tax bill
1. Learn how investments are taxed
Let’s say investors A and B both successfully compound their $1,000,000 portfolios into $1,100,000. They appear equally successful until the CRA intervenes. Investor A ends up surrendering nearly 40% of his profits to pay his tax bill, while Investor B accrues a tax liability for half this amount and could possibly defer this payment for years into the future. Who would you rather be?
Interest income, Canadian dividends, foreign dividends, and capital gains are the predominant sources of investment income earned by Canadians. Each is taxed differently. Understanding these differences can lead to more optimal portfolio decisions that reduce taxes and leave more wealth available to compound.
2. Learn how different accounts are taxed
Not only are the types of investment income taxed differently, but the account in which this income is earned has vastly different tax consequences. Income realized within a savings or taxable account is taxed immediately, taxes on income realized within an RRSP may be deferred to a future year, and income realized within a Tax-Free Savings Account is never taxed. Understanding the taxation differences between each of these accounts may allow investors to take advantage of tax-sheltering capabilities, and, once again, leave more of their wealth available to compound.
3. Build a comprehensive strategy
Once these tax concepts are understood, investors can build a comprehensive strategy that takes full advantage of the different tax-sheltering opportunities across their portfolios. Failure to merge these strategies into a thorough plan can yield sub-optimal results.
For example, Investor A has $1,000,000 of bonds in a taxable account, and $1,000,000 of stocks in a tax-deferred (RRSP) account. Each year, she is paying a 39% tax rate on the interest income earned by her bonds. Her stock portfolio is earning dividends and capital gains which are taxed more favourably than bonds, but because these investments are held in an RRSP, she wasn’t enjoying the more attractive tax rates. Our recommendation would be to swap strategies (i.e., we would hold the bonds in her RRSP and the stocks in her taxable account). This would not alter her overall portfolio in any way, but she would end up saving thousands of dollars in annual tax savings.
Due to the unique nature of each readers’ tax circumstances, we encourage you to seek the counsel of an investment professional to ensure you are exploring all possibilities to minimize your tax burden and maximize your compounding potential.