Most Canadians take advantage of tax sheltering within a Registered Retirement Savings Plan (RRSP) or through the tax-free benefits of a Tax-Free Savings Account (TFSA). However, outside of registered accounts, tax efficiency plays a key role in building wealth.
Tax efficiency is a key consideration in maximizing investment returns after taxes.
Dividends and capital gains receive preferential tax treatment relative to interest income.
Building an effectively diversified portfolio with tax efficiency in mind is a key way to building wealth and accelerate growth over time.
Each of these types of income are taxed differently by the Canada Revenue Agency. For example:
- Like wages, interest income typically earned on investments such as Guaranteed Investment Certificates (GICs) or savings deposit accounts is taxed at an individual’s highest marginal tax rate. This makes interest the least tax-efficient form of investment income.
- Dividends paid on stocks issued by eligible Canadian corporations receive more favourable tax treatment, since this type of income benefits from the federal dividend tax credit. In other words, dividend income is more tax-efficient than interest income. This means that investors in dividend-paying investments keep more of what they earn after taxes.
- Capital gains are triggered when you sell your investment for a higher price than your book value (also called adjusted cost base or ACB). Your book value is calculated by adding your total amount of contributions into a mutual fund, plus reinvested fund distributions, minus any withdrawals. Book value is used to determine if an investor is in a capital gain or loss position for tax purposes. Similar to dividend income, capital gains receive favourable tax treatment, since only half of a capital gain is taxed.
- Dividends and capital gains are typically earned on equity investments.
It's what you keep after tax that matters
After-tax returns illustrate your investment returns minus taxes. Simply put, if the one-year rate of return on an investment is 8% and an investor had a marginal tax rate of 26%, then the after-tax rate of return would be 5.9%.
Achieving tax efficiency within an investment portfolio is not just a strategy for people who need cash flow today. If your investment plan includes long-term goals, like a comfortable retirement, minimizing the amount of taxes you pay on your investments can have a tremendous impact on your portfolio over time. That is why building an effectively diversified portfolio — one that includes the appropriate mix of cash, fixed income and equities according to your investment objectives — is key to building wealth and accelerating growth over time. The types of investments you own and whether you hold them inside of or outside of registered plans (RRSPs and TFSAs) can have a bearing on the tax efficiency of your overall portfolio and, ultimately, on your ability to achieve your financial goals.
Three hypothetical portfolios and how they compare from a tax-efficiency standpoint
The following table provides a brief description of some of the different types of distributions that investors may receive from mutual funds and how each type is taxed.
What are the different types of distributions?
Here are descriptions of the different types of distributions you may receive from a mutual fund and how they are taxed.
You can stay on track to meet your long-term goals by building a tax-efficient investment portfolio with your advisor.