When formulating your investment strategy, you’ve probably focused on asset allocation, which involves balancing various types of investments like fixed-income, equities, and cash or equivalents to match your financial goals and risk tolerance. Yet, optimizing asset location for tax efficiency is frequently neglected. This refers to how your assets are distributed across different types of accounts—non-registered, registered, and sometimes, corporate accounts. Asset location is crucial because the taxation of investment income depends on where it is earned. Therefore, the type of income each investment generates and the account in which you hold it can significantly impact your after-tax returns.
Understanding Tax Implications of Investment Income
The kind of investment income you generate—be it interest income, Canadian dividend income, capital gains, or foreign income—has tax implications. Generally, interest and foreign income are taxed at your marginal rate, similar to employment income. Canadian dividend income is more tax-efficient due to the dividend tax credit, which lowers your tax liability. Capital gains are also tax-efficient, as only half of the gain is subject to tax.
Strategic Account Placement for Your Investments
Choosing the right types of investments is just the first step; you also need to decide where to hold them. Different accounts like Registered Retirement Savings Plans (RRSPs), Tax-Free Savings Accounts (TFSAs), and non-registered accounts have unique tax rules. By holding your investments in the most tax-efficient accounts, you could reduce your overall tax burden.
Here are some general guidelines:
- Fixed-Income Investments: Primarily generate interest income.
- Dividend-Paying Stocks: Usually produce dividend income and capital gains when sold.
- Other Investments: Mutual funds, ETFs, and REITs can generate a mix of income types—interest, dividends, capital gains, and return of capital. These may require individual analysis. For instance, a bond-focused mutual fund is more likely to generate interest income.
Remember, optimizing asset location across accounts is complex and may not suit everyone’s situation. Besides the type of income, consider factors like investment time horizon, contribution limits, personal tax rates, and expected returns. For example, you might usually avoid a foreign dividend-paying stock in your TFSA due to non-recoverable withholding taxes. However, if you expect significant growth in that security, holding it in a TFSA could be advantageous for tax-free capital gains.
| Account Types | Takeaways | Investments Worth Considering | Investments to Exercise Caution With |
| RRSPs, RRIFs, and Locked-in Plans | Income and capital gains are tax-deferred until withdrawn. Taxes are at your marginal rate upon withdrawal. U.S. withholding tax is exempted on U.S. interest and dividends under the Canada-U.S. tax treaty. | Canadian and U.S. interest-bearing assets like bonds, GICs, and T-bills. U.S. dividends. | Foreign (non-U.S.) interest and dividends. Canadian dividends. Capital gains. |
| TFSAs | Income and capital gains are tax-free, even upon withdrawal. | Canadian and U.S. interest-bearing assets. Canadian dividends. Capital gains. | U.S. and foreign dividends. Foreign (non-U.S.) interest. |
| Personal Non-Registered Accounts | Income and capital gains face annual taxation. | Capital gains. Canadian dividends. U.S. and foreign dividends (withheld taxes may qualify for a foreign tax credit). | Canadian and foreign interest-bearing assets like bonds, GICs, and T-bills. |
Optimizing After-Tax Returns for Non-Registered Accounts
From a tax standpoint, it’s often advantageous to hold equity investments like Canadian dividend-paying stocks in your non-registered accounts. This allows you to benefit from the preferential tax treatment of capital gains and dividends. On the other hand, fully taxed income investments such as interest-bearing assets are better placed in registered accounts like RRSPs to defer or even eliminate taxes on fully taxable income.
Foreign Income Considerations
When it comes to foreign income, the type of income and its source country are crucial factors. For instance, U.S. dividend-paying securities are generally better off in an RRSP, where no withholding tax applies, as opposed to a TFSA, where withholding tax on dividends is applicable. However, if the after-tax return on a U.S. security outperforms other investment options, you might still consider holding it in your TFSA.
Corporate Investment Accounts
If you own a corporation, optimizing asset location by incorporating your corporate investment account into your strategy is essential. Generally, income and capital gains earned within your corporation are categorized as passive investment income. This holds true whether you’re investing in an operating company or a holding company, and assumes that the income generated is not directly related to your business operations.
The taxation of passive investment income in a corporation is complex. For a more in-depth analysis, you may refer to our article on the subject. Broadly speaking, the Canadian tax system aims to neutralize any significant tax advantages or disadvantages of earning passive income through a corporation. However, the system isn’t perfect, and there is a tax cost in all provinces and territories when investment income is earned within the corporation and then distributed to shareholders.
Rules of Thumb for Corporate Investors
Despite these complexities, there are some general guidelines to consider for tax-efficient corporate investing. These can help you decide whether a particular type of investment aligns well with your corporation’s tax situation.
By understanding these tax nuances and strategically placing your investments across various accounts, you can optimize your after-tax returns, whether you’re an individual investor or a corporate entity.
Corporate Investment Accounts: Key Tax Considerations
When a private corporation earns passive investment income (excluding taxable Canadian dividends), it is subject to a general tax rate plus an additional refundable tax on the investment income. A portion of the total tax paid is refundable to the corporation when taxable dividends are paid out to the shareholders. The amount that is refundable to the corporation is reduced if the corporation earns foreign investment income and is eligible to claim foreign tax credit for the non-resident withholding tax paid. Taxable Canadian dividends earned in a private corporation from publicly traded securities are subject to a special refundable tax. This entire tax is refundable to the corporation once taxable dividends are paid out to the shareholders.
Consider Holding Canadian Dividends
When a corporation receives Canadian dividends, the entire tax paid on those dividends is refundable to the corporation once it pays a dividend to its shareholders. As a result, earning taxable Canadian dividends through a corporation is tax-neutral when compared to receiving those dividends on a personal level. Regarding capital gains, they are subject to a preferential tax rate when realized within a corporation. Additionally, any capital losses that are realized can be used to offset capital gains. If there is a positive balance in the capital dividend account, the non-taxable portion of the capital gain can be distributed to shareholders tax-free.
Generally Avoid Foreign Income
If a corporation generates investment income on which foreign taxes are withheld and then claims a foreign tax credit, the refundable portion of the tax is reduced. This action increases the overall combined corporate and personal tax rate on foreign dividends when they are earned within the corporation and subsequently distributed to the shareholder. In the case of U.S. and other foreign dividends, these are typically subject to withholding tax. For foreign interest income from countries other than the U.S., it is likely that withholding tax will also apply. Lastly, after foreign income, Canadian interest is considered the least tax-efficient form of income.
Balancing Tax Efficiency with Other Financial Goals
Considering Your Overall Objectives
While tax efficiency is a crucial aspect of building your investment portfolio, it shouldn’t overshadow your primary investing goals and risk tolerance. For instance, if you’re a conservative investor, you might naturally gravitate towards principal-protected investments like GICs. Knowing that interest income doesn’t receive tax-preferred treatment, you might be tempted to switch to investments that yield Canadian dividends or capital gains. However, high-risk equities with significant growth potential may not align with your investor profile.
It’s essential to consider various factors such as your specific needs, objectives, and time horizon. If you have surplus cash, evaluate whether you have immediate financial obligations like income tax installments or significant capital expenditures. If such needs exist, investing the funds may not be advisable. On the other hand, if you have no immediate requirements but may need the funds in the short to medium term, opt for liquid investments.
Long-Term Objectives
If your focus is on long-term objectives like boosting your retirement savings or enhancing your estate’s value, consider optimizing asset location and include investments that offer tax-sheltered growth and tax-free payouts.
Conclusion: The Importance of Optimizing Asset Location for Tax Efficiency
Remember, it’s not just about what you earn, but also what you keep. To maximize your earnings as an investor, a tax-efficient approach coupled with strategic asset location can go a long way in building and safeguarding your wealth. Collaborating with a Bristol Capital Management private wealth advisor and a qualified tax advisor can guide you in making well-informed decisions on the most tax-efficient investments or strategies suitable for your situation.