Smart tax-efficient investment strategies
We all want to pay less in taxes but that can be difficult when a significant portion of the tax we pay is determined as a percentage of our salary or income and our purchases of goods and services, respectively.
When it comes to investing, however, the tax you pay varies by the type of income or growth your investments generate. That’s why it’s important to invest strategically to reduce the tax you pay on your investment growth.
How is investment growth taxed?
There are three broad categories of investment income, each with its own tax implications.
- Interest and other income
The highest rate of tax is paid on interest income, which is the payment made to debtholders of a company, government or agency. These issues include guaranteed investment certificates (GICs), bonds and money market funds. Foreign investment income is taxed similarly. Depending on the nature of the investment your principal may or may not be guaranteed.
Dividends are payments made by corporations for owning their shares. These payments, which are distributed by a company from its earnings, are taxed to the recipient at a lower rate than interest income. Dividends are not guaranteed by the company and neither is your principal.
- Capital gains
Capital gains, which represent the difference in the amount you pay for the equity ownership of a company and the price at which you sell this equity (assuming a positive return is generated from that equity ownership), are taxed at the lowest rate of investment returns.
When your investment earns you $100, here’s what you’ll have after tax (assuming you’re in the highest tax bracket)
Source: Combined Top Marginal Tax Rates For Individuals in Ontario, 2015, and rounded to the nearest dollar. See iA Clarington 2016 Tax Reference Sheet.
Tax-efficient investing: Why it matters
When investing in a registered account like a registered retirement savings plan (RRSP), registered retirement income fund (RRIF) or tax-free savings account (TFSA), you don’t have to think too much about the nature of the income earned. Whether your investments generate interest, dividends or capital gains, none of these sources of investment growth are taxed when earned inside any of these accounts.
However, if you have maximized your contributions to your registered plans, or if you want additional flexibility in accessing your money, you may wish to invest in a non-registered account.
iA Clarington offers important strategies for deferring and reducing the tax you pay on non-registered investments.
The tax you pay on the different types of investments shouldn’t be your only consideration. You want to ensure your portfolio of investments matches your time horizon and risk tolerance, and is designed to help you meet your short-term and long-term financial needs.
That said, by reducing the tax you pay on your investments, you can save more over the longer term to help fund a more comfortable retirement, pay for a child’s education or purchase a large item like a house or a car.Tax efficient investing brochure
Benefit from funds with tax-efficient strategies
2016 Federal Budget Corporate Class changes – Effective January 1, 2017
On July 29, the Department of Finance released draft legislation to implement the 2016 Federal Budget changes. One of the changes is a proposal to amend the Income Tax Act (Canada) to eliminate the deferral of capital gains tax for investors switching between different classes of shares within a mutual fund corporation (the “Amendment”). The Amendment will apply to all mutual fund corporations across the mutual fund industry in Canada, including Clarington Sector Fund Inc. As a result of the Amendment, an exchange of shares between corporate class funds will be treated as a disposition at fair market value which will trigger capital gains or losses. The proposed change will not apply to switches between different series of the same corporate class fund.
One option for non-registered accounts is corporate class funds. A corporate class mutual fund is similar to a regular mutual fund (technically known as a “mutual fund trust”). But unlike a regular mutual fund, a corporate class fund is part of a larger corporation that holds a number of individual funds. As a shareholder of this corporation, you own “shares” of the corporate class mutual funds, not units (as is the case with mutual fund trusts).
Flexibility within the corporation
The main benefit of corporate class funds is that the corporation has the flexibility to shift gains from one fund to others in the corporation. This shift will spread out the gains in a tax-efficient manner so one fund is not saddled with an undue tax burden. That benefits you if you choose to sell shares. (This doesn’t mean they are changing the amount of return you receive.)
Payout options – Series T
Get income the tax-efficient way
Most of our Funds are available in Series T, which we’ve designed to provide you with a regular cash flow from your non-registered savings. And it does that in a way that may help to minimize the tax you owe when you receive that income.
Series T is most likely to benefit you when you retire and need to draw on your investment. It is expected that in the early years of your retirement, Series T will pay you a distribution made up of a combination of the income earned within the fund and a portion of your original investment. By doing this, you may be able to receive some of the gains you accumulated in those early years tax-free, thereby deferring to a later year some of the taxes payable. The portion of the distribution which is a return of your original investment is known as a return of capital or ROC.
Since the money you originally paid for the investment is being returned to you, the tax cost of your investments (your “adjusted cost base” or ACB) is reduced.
Later on, after the tax cost of your investments has been totally returned to you, subsequent excess distributions will represent capital gains, which are taxed more favourably than other types of investment income. Further, by this time you may also be in a lower tax bracket, meaning you would pay even less in tax.