Income tax is an expensive reality for Canadian investors. In many cases between one-third and one-half of investment income is lost to the tax collector. But by making the most of the tax-saving vehicles available, you can minimize the amount of tax you pay on your investments.
For the most part, this means keeping more highly taxed types of investments in tax-advantaged accounts, like RRSPs and TFSAs, and allocating investments that already have built-in tax breaks to a conventional "taxable" account. The following are some basic steps you can take to organize various streams of income so as to minimize the amount of income tax your pay.
RRSPs offer deferral, income-splitting. The registered retirement savings plan (RRSP) and its post-retirement successor, the registered retirement income fund (RRIF), are at the top of the list because they provide powerful, long-term deferrals of tax payable. These deferrals apply to the capital you invest (usually from employment earnings) in an RRSP, as well as the income and capital gains earned within the RRSP and, later, the RRIF.
The amount you invest in an RRSP each year is deductible from your total income. You don't pay tax on that income until you eventually withdraw money from the plan, normally after retirement when you are likely to be in a lower tax bracket.
The maximum contribution one can make to an RRSP for 2015 is $24,930, but cannot exceed 18% of your earned income (essentially your employment income plus specified other income as defined in the RRSP rules). The annual dollar limit rises each year to compensate for inflation. If you don't invest to your maximum allowable amount each year, those unused contributions are available for use in future years, in addition to each year's new maximum amount.
The deferral is extended from your RRSP to a RRIF, into which most people transfer their RRSP savings upon retirement. RRSPs must be converted to a RRIF (or to a registered annuity) by the end of the year in which you turn 71. A RRIF can be set up anytime, but money within a RRIF is subject to annual minimum withdrawals that vary according to your age.
As a result, most people delay the RRSP-to-RRIF conversion as long as possible. When money is withdrawn from an RRSP or RRIF, the entire amount (capital and income) is fully taxable. Similar rules apply to a locked-in retirement account (LIRA), which is where accrued benefits from a registered employee pension plan often are transferred when someone changes jobs. A LIRA's post-retirement successor is the life income fund (LIF), which is a type of RRIF.
A popular RRSP wrinkle is the spousal RRSP, which allows you to create two fairly equal streams of income after retirement. The goal is to put both spouses into lower tax brackets. The higher-income spouse contributes to an RRSP in his or her spouse's name, and receives the up-front tax deduction. The proceeds are taxed in the lower-income spouse's name when the money is eventually withdrawn.
TFSAs provide tax savings and flexibility. A tax-free savings account (TFSA) is an excellent long-term tax-savings vehicle and is much simpler than an RRSP. You don't get a tax deduction when you contribute to a TFSA. But any income or capital gains earned within the account grows tax-free. Nor is any tax payable when you make withdrawals. The annual contribution limit is $10,000, with no income-related restriction. As with RRSPs, unused contribution amounts become contribution room for future use.
RESP income is taxed in student's hands. A registered education savings plan (RESP) allows you to save for a child's post-secondary education. Contributions are not tax-deductible, but the income earned within a plan is not taxed until money is withdrawn to pay education costs. The income is taxed in the child's hands, which means little or no tax will be payable.
Up to $50,000 can be contributed over the years (some contribute it as a lump sum when a plan is set up) toward an individual beneficiary's future education. Contributions can be made for up to 31 years from the time a plan is opened.
The contributor has the flexibility to withdraw his or her capital tax-free at any time, but if the withdrawals exceed the amount contributed, the excess would be taxable. For more details on RESPS, click here.
Make the most of investment-related tax breaks. It makes sense to hold investments that produce dividends and/or capital gains in non-registered accounts, and interest-bearing holdings in your registered accounts. This allows you to take full advantage of tax credits for Canadian dividend income, and the fact that only half of capital gains are taxable. However, shares of companies based outside Canada do not qualify for dividend tax credits, so it's better to hold dividend-paying U.S. and international equities within a registered plan. Real estate investment trusts (REITs), whose income distributions are fully taxable, are also suitable candidates for inclusion in a registered plan.
Of course, this "asset-location" strategy works only if you have enough money to invest beyond the allowable maximum contributions to the various registered plans. Moreover, RRSPs, TFSAs and RESPs are designed to generate long-term asset growth to fund retirement, future major purchases and/or a child's education, and thus need to be invested for growth. You should simply be aware that dividends and capital gains are less heavily taxed than interest, and make your allocations between registered and non-registered accounts accordingly.
For example, if in a given year you had enough cash to use all of your RRSP and TFSA contribution room, and have enough left over to invest in a non-registered (taxable) account, you could decide to buy stocks for investment outside those plans and interest-bearing assets to hold within them. However, as always, particularly if you have many years to go before withdrawing money from a registered plan, make sure you are invested within those plans to meet your growth targets, at acceptable levels of risk.
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