Besides market fluctuations and interest rates, there’s another factor that can boost or diminish the returns from your investments: taxes.
Tax-efficient investing is an investment strategy that aims to minimize the taxes investors will pay on investment gains, in order to maximize their after-tax returns. Learning how to be tax-efficient before you make an investment will help you minimize pain and maximize gain when tax season arrives.
Gains and income generated by investments need to be reported on tax returns. How it gets taxed depends on the type of investment (bonds, stocks, cryptocurrency, and so on) and what accounts you used to make those investments (such as a TFSA, RRSP, or a non-registered account). For instance, if you sell mutual funds at a gain, that gain is usually considered a capital gain, which is taxed at a certain percentage. But if you’ve invested in stocks, any dividends you earn are taxed differently.
These different tax treatments can help or or hurt your returns. This is where tax-efficient investing comes in.
Things that can increase your taxes from investing
Taxes impact your total investment return. But some sources of investment return are more or less tax-efficient than others. Here are a few examples:
Dividends. The dividends you earn as a shareholder in a company are taxed at a higher rate than capital gains, so they can reduce your returns. But if you own shares in a Canadian company, you may be eligible for the Dividend Tax Credit. Because dividends are paid to shareholders with a company’s after-tax profit, this credit helps offset any double taxation that may occur.
Bonds. Interest earned on bonds is even less tax-efficient than dividends; it’s taxed as income, and you can’t offset it with tax credits or reductions.
ETFs. Some ETFs can convert dividends to capital gains, using “corporate class” or “swap-based” structures. Choosing these ETFs can improve after-tax total returns more than choosing an ETF with a lower Management Expense Ratio (MER).
Ways to invest more efficiently for taxes
Tax-efficient investing is largely based on the types of investments you choose and the accounts you use. Here are a few different ways to invest more efficiently:
Tax-aware asset allocation. This means choosing a strategic mix of assets that help you diversify while also minimizing the effects of taxes. Some asset classes — such as bonds, stocks, cryptocurrency, or hedge funds — or combination of asset classes offer similar diversification properties but yield different returns. Choosing a lower-yielding asset class can reduce your overall tax bill.
Account type. Choosing which accounts to hold higher- or lower-returning assets in can reduce your overall tax burden. For instance, returns on most investments made in a TFSA are tax-free, meaning your income or gains are maximized. If you hold investments in an RRSP or FHSA, the taxes on any gains or income are deferred; you won’t pay taxes until you withdraw money from the account.
Tax-aware security selection. If you’re investing in international stocks, some account types may offer tax credits or reimbursement for taxes paid abroad. Dividends paid on U.S. stocks are subject to a 15% withholding tax in Canada, but certain accounts — such as an RRSP — can eliminate this tax. Understanding these rules can help you reduce taxes on international investments.
Tax-loss harvesting. If you have an investment that has lost value since you purchased it, you can sell that investment and use the loss to offset capital gains elsewhere in your portfolio. You can’t buy the exact same stock back, but you can buy a similar stock (such as from a competing company) in order to maintain similar diversification and exposure in your portfolio.
