Design Tax-Efficient Portfolios

Never heard of building tax-efficient portfolios? Don’t worry, as this method may not apply to you yet. Before you get to that stage, ensure you are maximizing contributions to registered accounts that benefit your household (such as RRSPs, TFSAs, and RESPs) before investing outside these accounts. Otherwise, take the steps outlined below for each stage to build tax-efficient portfolios throughout your career.

Early Career?

If you are early in your career, you’re probably in the acquiring stage, either adding to, or trying to pay off, debt such as a mortgage or student loan payments. Your only investments may be through your employer, such as a pension plan, RRSP or company shares. You may have more RRSP room than you can use and all your retirement savings are likely in registered plans (such as a pension or an RRSP). Tax efficiency really doesn’t matter if all your investments are in pension or RRSP accounts.

Mid- to Late Career?

When you have acquired more assets, paid off your debts and set up multiple investment accounts, it’s time to think about tax-efficient portfolios. Tax efficiency is all about saving tax, now or later, by holding your equities and fixed income assets in the most tax-efficient account.

Do You Own Multiple Accounts?

Do you own a combination of registered and non-registered accounts? If so, it’s time to build tax-efficient portfolios. This requires several steps.

1. Review all your accounts. List each account owned and note the tax advantages between accounts: Examine the differences in how investment distributions (income and capital gains/withdrawals) are taxed, as illustrated in the table below.

* Cells shaded in orange indicate important tax advantages

 

RRSPs/DC/Locked-In

RESPs

TFSAs

Non-Registered

Contributions

Before-tax dollars (or tax refund based on your tax rate)

After-tax dollars

After-tax dollars

After-tax dollars

Government grant

No

Yes, CESG to eligible child

No

No

Tax on investment earnings (e.g., interest, dividends or capital gains)

No

No

No, unless taxed by a foreign government

Yes, in year received or accrued

Capital gains at 50% rate in year deemed disposed

Withdrawals taxed

Yes, added to income in year withdrawn

Investment earnings and CESG, in hands of eligible child

Principal, not taxed

No

No

Withdrawals may be re-contributed in a future year

No

No

Yes

Not applicable

Income splitting

Yes, your contributions may go into a spousal RRSP

Yes, CESG and income withdrawn are taxed in child’s name

Yes, you may contribute to another individual’s TFSA

Limited, investment income and capital gains are attributed back to the contributor

Who benefits the most?

Those who are in a much higher tax bracket when contributing money than when withdrawing it

The child named as the beneficiary

Those who realize a high rate of return on their investments

Those who generate dividends or capital gains, which are taxed more favourably than interest

 

2. Compare the pros and cons of holding interest-bearing cash and fixed income assets versus dividend and capital gains equity assets in each type of account. These are illustrated in the following table.

 

RRSPs/DC/Locked-In

RESPs

TFSAs

Non-Registered

Interest

Tax-sheltered

Tax-sheltered

Tax-sheltered

100% taxable

Eligible Canadian Dividends

Tax-sheltered

Tax-sheltered

Tax-sheltered

Reduced tax rate: Dividend tax credit

Foreign Investment Income

Usually tax exempt

Foreign government withholds tax

Foreign government withholds tax

100% taxable

Capital Gain

Tax-sheltered

Tax-sheltered

Tax-sheltered: not taxed when withdrawn

Tax at 50%; in year deemed disposed

Capital Losses

Future taxable withdrawals reduced, equivalent to a deduction

Future taxable withdrawals reduced, equivalent to a deduction

Not taxed when withdrawn; no deduction available

At 50% rate: to offset capital gains


3. Group accounts into separate portfolios based on the investment objective (for example, all assets meant for retirement will be treated as one portfolio). You are now ready to build tax efficiency into the portfolios that comprise multiple accounts. 

The following considerations will affect the tax efficiency of your portfolio:

  • Foreign dividends in non-registered accounts are taxed like interest; no tax advantage occurs.
  • Income earned within TFSAs and RRSPs is left off an individual’s Canadian income tax and benefit return. If the income is not included on the Canadian income tax and benefit return, there is no opportunity to claim a foreign tax credit for foreign withholding on foreign-source dividends.
  • Foreign dividends paid into a Canadian RRSP from treaty countries (countries with whom Canada shares a tax treaty) are exempt from the above-noted withholding tax.
  • TFSAs do not boast the tax advantage noted above. Foreign dividends on securities held within a TFSA are subject to withholding tax and tax paid cannot be used as a foreign tax credit (as TFSA income is not reported on a Canadian income tax and benefit return). One solution to this problem is to hold foreign securities that do NOT pay dividends within one’s TFSA.
  • Interest rates are expected to remain low in the near future.
  • Equity investments have historically grown faster than interest-bearing investments.

 

Increase Your Tax Efficiency

Do you own a combination of registered and non-registered accounts? If so, it's time to build tax-efficient portfolios. Click the button below to start.

 

 

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Weighing in on Tax Efficiency

In the world of investing, professionals have different opinions regarding which assets belong in different types of accounts. There is no clear consensus. In this overview, two professionals weigh in. You be the judge. Click the button below to start.

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To learn more about investing and the taxman, see the section Tax: Investing & the Taxman, which provides a comprehensive overview of this topic.