When my daughter landed her first solid job in Prince George as a lifeguard, she was feeling on top of the world until her pay cheque arrived. Then she yelped as though she had been robbed: "What's this deduction off my cheque? I never agreed to this!"
Welcome to my world, sweatheart.
Taxation is as difficult to avoid as getting up for work. However, a few tips for investors can help wrestle the matter down a little:
Non-Registered Accounts
By definition, these accounts are not sheltered from taxation and thus we should carefully examine the sorts of income we generate within them. Capital gains and dividends receive preferential tax treatment over interest income, making ownership investments in companies more attractive from a tax perspective than lending to them. Tax strategy should never trump common sense or risk preference, but it should be a consideration in the risk/return analysis.
Certain investments, such as real estate investment trusts (REITs), royalty income trusts, as well as some mutual funds, can distribute a non-taxable return of capital payment to you. This means they initially pay you with your own money, a deferral (pay tax later) strategy. The distributions reduce the cost base of the investment for income tax purposes. As a result, although the distributions are not taxable in the year received, they result in capital gains later (or a smaller capital loss) when sold. This allows you to convert high-taxed interest to lower-taxed capital gains and benefit from the deferral of tax and the time value of money.
You may also wish to consider delaying the sale of a security with accrued capital gains to a year when your income will be lower or you have capital losses to offset the gains.
Tax Loss Selling
If your portfolio contains investments that have decreased in value prior to the end of the calendar year, consider selling these investments to recognize a capital loss. This capital loss can be used to reduce capital gains realized in the current year, in the three previous taxation years, or in future years. Note: If you intend to repurchase the investment, ensure that you do not invoke the "superficial loss" rules.
Registered Accounts
Contributing to an RRSP provides you with a tax deduction today and defers the tax on the full amount of the contribution until the funds are withdrawn. RRSP's allow your investments to grow tax-free during your higher income working years. Then, during your retirement years, when you start withdrawing taxable income, you will likely be in a lower tax bracket since your income from all sources will likely be lower than it is during your working years.
Tax-Free Savings Account (TFSA)
Since January 1, 2009, you have been able to use the TFSA to save $5,000 per year for a variety of your short-term and long-term goals with the benefit of tax-free growth. The funds within the TFSA can grow sheltered from tax; however, contributions are not tax deductible. Remember, the only advantage to a TFSA is that your growth is not taxable. This makes modest interest earned on some TFSA accounts far less appealing.
Tax Shelters - Proceed with Caution
There are certain investments which offer tax incentives such as flow-through shares. Flow-through shares are relatively high risk investments offered by companies in the mining, oil and gas, and energy sectors to help finance their exploration and project development activities. The companies then renounce or "flow through" eligible expenses to you, the investor, up to an amount equal to the cash you paid for the shares. Depending on the type of tax shelter, you are able to claim a deduction for the full amount of funds invested, with most of the deduction available in the year you made the investment, and the balance deductible in the following one or two years. Since they are generally deemed to have a tax cost of nil, any proceeds derived from the investment's sale in the future would trigger a capital gain, which is only 50% taxable. Just a cautionary note, when it comes to investments offering tax incentives, it's crucial to focus on the quality of the investment and not just the tax incentives.
Mark Ryan is an advisor with RBC Wealth Management, Dominion Securities (member CIPF) and can be reached at [email protected].
This information is not intended as nor does it constitute tax or legal advice. Readers should consult their own lawyer, accountant or other professional advisor when planning to implement a strategy.
