“The hardest thing to understand in the world is income tax” – Albert Einstein
Tax time is in full force and is on everyone’s mind.
It is a good idea to review your tax return each year and compare it with the previous year. This gives you an idea if you are paying more or less in taxes than usual, and whether there are areas to reduce your bill. It is also a good time to take a look at your current portfolio and ensure that it is set up in the most tax efficient manner for your personal situation, because paying less tax is always better.
Part of what your adviser should be recommending is how to create a tax-efficient portfolio for you, which includes different ways to set up your portfolio to pay lower taxes. We work hard to earn our money – it is just as important to look at ways to preserve it.
Not all investment income is created equal when it comes to taxes. There are three main types: Interest, dividends and capital gains. If you are an investor owning both registered and non-registered accounts, there are strategies you can deploy to reduce the tax liability of your portfolio. Bonds and GIC’s pay interest income, and this interest income is taxed fully at the same rate as your employment income – and at your highest marginal rate. It’s more beneficial to hold fixed income inside of your RRSP or RRIF accounts, as you defer the taxes until it’s withdrawn. On the other hand, dividends and capital gains get preferred tax treatment through tax credits and 50 per cent inclusion rates. You can earn dividends and capital gains through stock (equity) investments. Therefore, it is more tax efficient to hold most equities in your non-registered accounts. This strategy re-arranges your investment income to help reduce how much tax you pay overall.
Another way to reduce taxes is to look at separately managed accounts (SMAs), or wrap accounts. These are managed portfolios where you own and see all the individual securities in your own account. SMAs aren’t for everyone as they typically have an investment minimum of $100,000 per account, but some clients appreciate them because of their ability to potentially reduce taxes that they owe on capital gains. These type of accounts offer tax-loss harvesting, which can allow investors to make trades to systematically capture realized losses, without selling out of the strategy. Additionally, unlike mutual funds, SMAs do not produce year end capital gains distributions. When you buy shares of a mutual fund, you automatically get a share of its accrued tax liabilities if they have not paid the income out yet. Mutual funds are required to pay out realized income to all fund holders, regardless of how long you have held their shares. For example, if you buy a mutual fund right before a distribution date, you may have to pay taxes on the income you haven’t earned yet.
Another strategy that is beneficial to reducing your overall taxes is through setting up joint accounts with your spouse. You can’t avoid the income taxes, but you can split the income. It is important to ensure that it is set up properly with the advice of a tax specialist or accountant. A spousal loan might be required, but not always. At the least, a joint account will save you probate fees if one spouse passes away, which can add up.
Although tax time can be a hectic time of the year, your financial team should be reviewing your tax situation on an annual basis ensuring you feel organized and ready to submit your tax return.Be sure to file by the April 30 deadline.
Lori Pinkowski is a senior portfolio manager and senior vice-president at Raymond James Ltd., a member of the Canadian Investor Protection Fund. This is for informational purposes only and does not necessarily reflect the opinions of Raymond James. Lori can answer any questions at 604-915-LORI or firstname.lastname@example.org. You can also listen to her every Wednesday morning on CKNW at 8:40 a.m.