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Take advantage of tax rules when investing outside your RRSP
If you have a non-RRSP account, you need to consider tax aspects. If not, your investment income and returns will be reduced by taxes.
Fortunately, you can maximize net (after-tax) returns of your non-RRSP investment portfolio. How? By choosing investments with tax-efficient income. In other words, you should focus on equities and avoid fixed-income securities.
Focus on equities
Equity funds generate tax-efficient benefits: dividends and capital gains.
Dividends
Dividends give rise to a tax credit that is granted by governments to shareholders in order to encourage investments in Canadian companies.
This tax credit, which is applied to the dividend amount grossed up by 25%, currently amounts to:
 | 13.33% for federal tax purposes
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| 10.83% for Québec tax purposes |
Example: You receive $100 in dividends and after grossing up by 25%, this amounts to $125. Tax is calculated on the grossed-up amount:
Federal tax credit
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$125 X 13.33%
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=
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$16.66
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Québec tax credit
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$125 X 10.83%
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=
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$13.54
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Total tax credit
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$30.20
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If your marginal tax rate is, for example, 50%, the tax liability on dividend income should have been $62.50 ($125 X 50%). Thanks to the tax credit of $30.20, the tax will only amount to $32.30 ($62.50 - $30.20 = $32.30).
Capital gains
What are capital gains? This is quite simply the profits realized when you sell a security at a price higher than the initial cost. For example, by selling at $20 a stock purchased at $10, you will make a capital gain of $10.
You can also generate capital gains when selling your fund units.
Similarly, a manager of an equity fund can also generate capital gains by selling some portfolio holdings. At the end of the year, the company operating the fund has to decide whether or not to distribute such capital gains to unitholders.
Whether the capital gain results from a sale made by you or from a fund distribution, the rule is the same: only half the gain is added to your taxable income. In other words, only 50% of the capital gains is taxed.
Assuming a marginal tax rate of 50% as in the previous example, a capital gain of $100 will result in a tax liability of $25 since only half the gain or $50 is taxable.
Avoid fixed-income securities
Interest generated by bonds and other fixed-income securities is 100% taxable. This is true even if the interest has not been actually received as in the case of compound interest! Thus, interest is the most heavily taxed investment income.
Assuming once again a tax rate of 50%, you can see below how tax on a $100 investment income can vary, depending on the underlying asset category:
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Tax liability
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Net income
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Interest-fixed
income security
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$50.00
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$50.00
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Capital gains
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$32.30
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$67.70
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Capital gains
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$25.00
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$75.00
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Since interest income carries the heaviest tax burden, it is perhaps not advisable to hold investments that generate such income in your non-RRSP portfolio.
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