STRATEGIES TO LOWER INVESTMENT TAXES
Understand your options and take advantage of ones that work for you
Would you rather make six per cent or five per cent on your investments?
Believe it or not, some investment managers and self-directed investors would rather earn five per cent. The reason is that they don’t pay any attention to taxes.
By way of example, it is possible for some individuals to make a 10 per cent return on their investments, but they then have to pay five per cent in taxes, leaving just five per cent in their pocket. At the same time, someone can earn seven per cent, but only have to pay one per cent in taxes, leaving six per cent in their pocket. Many people focus only on the before tax return when it’s the after tax return that really matters.
All of this gets us to the issue of how to be a tax efficient investor.
If you have all of your investments in RRSPs, RRIFs or TFSAs, then investment taxes are not a concern for you. However, most high-net-worth Canadians have meaningful money that is not sheltered from tax. This also can become an issue rather suddenly for many investors if they receive a sizable inheritance, receive the commuted value from their pension or sell their house.
For those of you for whom taxes on investments are an important issue, here are three ways to lower your investment taxes.
1. Buy stocks with no income — and don’t sell them With all of the focus on income and dividend yields, we sometimes forget one of the reasons that some companies pay no dividend: They actually believe that reinvesting in the company is more valuable than giving the cash to shareholders. The tax benefit is that you have no income to report each year. The best Canadian example would be CGI Group. The stock pays no dividend, but the share price is up over 200 per cent over the past five years. If you bought and held this stock, you would have reported $0 in investment income — even if you had $1 million in the stock.
Of course, when you actually sell the stock, you will face capital gains taxes, but the tax rate will be half that of your interest income in any year.
The downside is that if the stock is not doing well, you don’t even have a regular dividend to keep you company.
2. Invest taxable money where it won’t be taxed The best tax shelter in Canada is a principal residence. So why not buy a bigger house or move to a nicer neighbourhood?
I know that there may be many practical reasons not to do so, but from a pure tax focus, investing more in a principal residence allows for complete tax-free growth (except for the higher annual real estate tax bill).
Another option is to purchase a universal life insurance policy (or use an existing policy), and invest extra money within it. This will grow tax sheltered up to certain specified tax limits. These may not be the most flexible or liquid investment strategies, but they will lower your annual tax bill.
3. Spousal loans at one per cent If one member of a couple is in the top tax bracket and the other member is not working, and you have meaningful non-registered investment assets, then you have the ideal scenario for a spousal loan.
The idea is that the highincome spouse lends the lowincome spouse money and that money is used to purchase investments that are held in the low-income spouses’ name. In Ontario that could mean the difference between paying 49.5 cents on $1 of investment income in the hands of one spouse, and 20 cents on the dollar in the hands of the other. Of interest, the strategy makes less sense in Alberta because the gap in tax rate from high income to low income is much smaller (40 per cent to 25 per cent).
In order to make this happen properly, the low-income spouse must pay interest each year to the high-income spouse at a rate of just one per cent (using the current rate provided by CRA). The great news is that this rate will hold for as long as the loan is in place. In other words, this low one per cent rate could last for the rest of your life. A higher rate makes this strategy more expensive, because the loan interest is treated as income in the hands of the higher income spouse (and as an expense for the lower income spouse).
As you can see, each of these tax driven strategies has an obvious benefit, but they usually have some downside as well.
From my perspective, the key is to understand the options and perhaps take advantage of a few that might add value to your particular situation.
To simply ignore the tax side of the investment equation is just bad investment and wealth management.
To simply ignore the tax side of the investment equation is just bad investment and wealth management.