Investment Accounts & Your Marginal Tax Rate

Your marginal tax rate (MTR) is the amount of income tax imposed on your next dollar of earned income. In a progressive tax system, if you can lower the amount of taxable income, you may be able to lower your MTR. If you increase your taxable income, you may increase your MTR. As a result, your investment activities and accounts will both affect, and be affected by, your MTR.

RRSPs and Your MTR

Knowing your MTR is important when considering an RRSP contribution. In which tax bracket does your taxable income fall? Making a contribution into an RRSP effectively removes the same amount off your taxable income (because you get a tax refund). Therefore, you can calculate the amount your tax refund will be, or conversely, the amount you won’t get back if you don’t make the contribution.

RRSPs vs. Investments

An RRSP is not an investment. It’s an account into which you put cash and then purchase investments with the cash. You can have the same investment (that is, a stock or a mutual fund) inside or outside an RRSP. The only difference is the RRSP generates a tax refund when the initial money was contributed and there are no ongoing taxes on the investment income. At withdrawal, you’re taxed at your marginal tax rate on every dollar taken out.

Taxable Investments

Investments held outside a registered plan are referred to as non-registered or taxable investments. The income (such as interest and dividends) is taxed when received or accrued. Capital gains from these investments are taxable when an investment is liquidated but not the amount of money originally invested as it is considered “tax-paid”.

Examples of taxable investments include:

  • Stocks, bonds, mutual funds and GICs, held in a “cash”, “open” or “investment” account with a brokerage, bank, investment management firm or other financial institution
  • Investment real estate

A Special Case: Life Insurance as an Investment

Life insurance is often represented as a tax shelter, since it is assumed the proceeds are received tax-free. However, you should take note of the following:

  • To realize the tax-free component of a plan, the insured individual has to die.
  • If the cash surrender value (cash accumulation) is redeemed, tax must be paid on the investment earnings.
  • Premium costs are not tax deductible and the cash accumulation (cash surrender value) will not grow at as great a rate as other investments, particularly in the early years of the policy.
  • Investments in a savings feature of a life insurance policy should be treated as an investment and compared with other investments, all on an after-tax basis, to assess the relative rates of return (using your marginal tax rate).
  • Investment choices are limited. Fees and other charges may be comparatively high.