Your personal 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 familiar with the tax implication can help increase the after-tax return on your investments.
This article will focus on the taxation of investment portfolio. These include investments in marketable securities, and not private companies or real estate investment. Investment in private companies or real property is generally restricted or not allowed in most registered plans.
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.
Portfolio investments in Canada
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. For purpose of illustration we will use the personal tax rates in Ontario. The same rules would apply if you are living in a difference province.
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. The top marginal tax rate in Ontario for investment income earned outside of non-registered accounts is 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.
Capital gains and losses
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. Note that capital losses in a registered account (RRSP, RRIF, or TFSA) cannot be used to offset capital gains realized in a non-registered account.
Capital gains are only taxed when they are realized (i.e. 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 in your RRSP, where the tax on capital gains will be deferred. Hold the stocks you intend to hold long-term 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 and 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 CRA. If the cost of all of the foreign securities, plus any other reportable foreign assets that you own, is more than $100,000 CAD, 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.
Analysis – RRSPs vs. non-registered accounts
As you are analyzing the taxation of investment portfolio, 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 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.
Analysis – 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.
Once a portfolio has been established, you should 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. You should also keep in mind that the Canadian 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. Speak to a qualified tax specialist if you require further assistance on the taxation of investment portfolio.