Tax Efficient Investing - Part 2

Two weeks ago I discussed tax efficient investing within a TFSA. Today I conclude this discussion with a review of tax-efficient investing options within non-registered accounts, TFSAs and RESPS.

Non-registered Account

To ensure we are on the same wavelength, when I say non-registered, I am talking about taxable investment accounts you hold, excluding RRSPs, RESPs and TFSAs.

I don’t want to be repetitive, so I will not again list the non-tax considerations one must account for before determining the most tax efficient use of this account (see these considerations in the TFSA discussion from the first post). However, one specific consideration applicable to non-registered accounts is your capital loss carryforward balance. If you have capital loss carryforwards, you will want to use these losses against future capital gains and have a definite bias towards holding equities that will produce capital gains.

For non-registered accounts, since they are taxable at your marginal rate, you will typically want to hold investments that are subject to the lowest tax rates.

1. Equities – since capital gains are subject to a 50% inclusion, you typically will prefer to hold your equities in your non-registered account, as they result in the lowest tax cost, say 26% or so at the highest marginal rate, as opposed to say interest instruments that would result in a 53% tax cost.

2. Canadian Dividends – since you receive a dividend tax credit for both eligible and non-eligible dividends, you will have a tax preference to use the dividend tax credits in your non-registered account or you lose the credit. Eligible dividends which come typically from public corporations are preferable to non-eligible dividends.

3. REIT – since you receive tax-free distributions of ROC and this ROC reduces your ACB resulting in larger capital gains, you may wish to hold a REITs or ROC type investment in a non-registered account. You will consider this if you are willing to deal with tracking the ACB (see the first post) and the REIT is not allocating significant other income that is subject to the high marginal rates. Note, if the ROC is not large or declining, you will likely not want to hold REITs in your non-registered account and may wish to hold them in your TFSA in any event to avoid the "tracking hassle".

RRSP

For registered accounts, since the income is earned tax-free before you start withdrawing from your RRSP/RRIF, you will typically want to hold investments that have the highest tax rates attached to them. In general you will not want to hold high growth equity, since even though large gains will be deferred and can compound tax-free within the RRSP, when you withdraw the funds, the 26% capital gain rate essentially becomes 53% if you withdraw money from your RRSP/RRIF at the high rate of tax. Thus you will have effectively lost the 50% tax savings associated with a capital gain (although you will have deferred the tax possibly many years).

1. U.S. Stocks that Pay Dividends – there is no foreign withholding tax on U.S. dividends paid to an RRSP, so an RRSP is very tax effective for such dividends. US dividends received by a non-registered account are taxed as regular income (as noted in the first post on this topic, US dividends in a TFSA are subject to the tax withholding with no tax credit benefit). Keep in mind, this tax treatment is specific to U.S. stocks and does not necessarily apply to other countries.

2. Fixed Income – because these investments are fully taxable, the tax savings are maximized in an RRSP. Conceptually, using fixed income prevents your RRSP from growing larger, since you do not have as large an equity component. However, in a balanced overall portfolio, you will likely have held that part of your equity component in lower taxing non-registered or TFSA accounts, so overall your total retirement pie should be somewhat equivalent.

Thus, when you start making RRSP withdrawals for your retirement, you will likely have a more effective taxable mix coming from smaller RRSP balance (that may be taxable at your highest marginal rate) with a mix of retirement funds that grew more tax effectively in your TFSA (that can be withdrawn tax free) and/or non-registered account, that may result in a lower overall tax cost at retirement.

RESP

These accounts have a singular purpose -- funding your children’s education. Thus, many experts suggest these accounts should have a more conservative bent. However, if you start the account for your child or children, at a very early age, you will be able to invest through one or two investment cycles and a well balance diversified portfolio may make sense, but speak to your investment advisor for their input.

As I stated at the outset of this series, tax and investment decisions should not be made in isolation, and tax efficiency must be considered in context of portfolio risk management and asset allocation. Once you have considered these issues, then the tax efficiencies above should be considered.

The above in not intended to provide investment advice. Please speak to your investment advisor.

This site provides general information on various tax issues and other matters. The information is not intended to constitute professional advice and may not be appropriate for a specific individual or fact situation. It is written by the author solely in their personal capacity and cannot be attributed to the accounting firm with which they are affiliated. It is not intended to constitute professional advice, and neither the author nor the firm with which the author is associated shall accept any liability in respect of any reliance on the information contained herein. Readers should always consult with their professional advisors in respect of their particular situation. Please note the blog post is time sensitive and subject to changes in legislation or law.

Tax Efficient Investing - Part 1

A couple of months ago, Rob Carrick of The Globe and Mail interviewed me for an article he was writing on Tax-Free Savings Accounts (“TFSAs”). Specifically, he was asking me whether Real Estate Investment Trusts (“REITs”) and other Return of Capital (“ROC”) type instruments should be purchased in a TFSA. I will leave you in suspense for a while on the answer to that question… but Rob’s question made me realize I had never written a blog post solely dedicated to the tax efficiency of the four main types of accounts that Canadians hold:

1. TFSA

2. Non-registered Account

3. Registered Retirement Savings Plan (“RRSP”)

4. Registered Education Savings Plan (“RESP”)

Today and next week I will discuss this topic.

Overall Conclusion

Once I had completed the initial draft for this post, I reflected upon what I had written and I came to two conclusions:

1. Tax and investment decisions should not be made in isolation

2. Tax efficiency must be considered in context of portfolio risk management and asset allocation

Please keep these in mind as I discuss the individual accounts.

TFSA

A perfect example of why I say tax efficiency must be considered in context of portfolio risk management and asset allocation is a TFSA.

There are several non-tax considerations one must account for before determining the most tax efficient use of this account. These include:

· Age – with a longer time horizon, you may want a higher exposure to Canadian equities to maximize your investment returns.

· Overall Portfolio Allocation – for all the accounts discussed, you must ensure tax efficiency in the context of your overall portfolio allocation.

For example, let’s say your portfolio allocation for REITs is 4%. If you decide a REIT is the most efficient investment for your TFSA and invest 3% of your overall portfolio in REITs within your TFSA, you must ensure you only have 1% weight to REITs in all your accounts.

· Risk – you may have read one of the articles about Canadians who have already grown their TFSAs to several hundred thousand dollars and how some are being audited by the CRA. Ignoring those who manipulated their TFSAs, many people with high value TFSAs achieved their growth through purchasing speculative or high growth equities within their TFSAs. But you must also consider that high growth equities can also produce large capital losses and those losses are lost within a TFSA.

· Need – where your TFSA is acting in part or whole as an emergency fund or you have a low risk tolerance, you will likely be considering only liquid and low risk options such as money market and maybe bonds.

As can be observed above, your selection of investment type for your TFSA may be subject to multiple non-tax considerations. However, for purposes of this post, let’s assume you just want to know what types of investments are generally the most tax efficient for a TFSA. I discuss these below:

1. High Yield Income – while these investments are far and few between; if you were able to invest in a high-yield mortgage fund or something similar, you would be saving around 53% in tax at the highest marginal rate.

2. Stocks – whether you are willing to take the risk and purchase high growth equity or want more stable Canadian equities that pay dividends, both these investment types would save you up to 26% in tax at the highest marginal tax rate; however, as noted above, any capital losses are wasted. One could argue a TFSA is not the best place for equities since you only save 26% versus 53%. However, equities may provide a return of a significant quantum that has many years to grow and compound the “large” tax-free gain.

3. REIT – technically, there is no correct answer here. You have to review what proportion of your investment return is ROC vs income, dividend or capital gain. If you have a high ROC, you are giving up a tax-free return that can be received elsewhere by holding your REIT in a TFSA (it should be noted that the ROC reduces the adjusted cost base (“ACB”) of the REIT and creates a larger capital gain down the road). So while a REIT is a tax efficient investment within a TFSA, an argument could also be made that a REIT may also be tax effective in a non-registered account. Yet, surprisingly, for many people, the overriding reason they put REITs in their TFSAs is not the tax savings, but the ability to relieve themselves from the tax administration hassle of tracking the ACB of a stock that has a ROC.

You will typically not want to hold a foreign stock (especially a US stock) that pays dividends in a TFSA, since foreign tax will be withheld and you will not be able to take advantage of the foreign tax credit for that tax withheld in your TFSA.

The above in not intended to provide investment advice. Please speak to your investment advisor.

Next week I will conclude this discussion, when I review tax efficiency within non-registered accounts and RRSPs and RESPs.

This site provides general information on various tax issues and other matters. The information is not intended to constitute professional advice and may not be appropriate for a specific individual or fact situation. It is written by the author solely in their personal capacity and cannot be attributed to the accounting firm with which they are affiliated. It is not intended to constitute professional advice, and neither the author nor the firm with which the author is associated shall accept any liability in respect of any reliance on the information contained herein. Readers should always consult with their professional advisors in respect of their particular situation. Please note the blog post is time sensitive and subject to changes in legislation or law.