How to invest tax-efficiently in a non-registered account

No one ever said that choosing investments is a simple business. For any investor, several factors need to be considered, including age, investment objectives and one’s willingness and ability to tolerate risk. There’s also the impact of taxes on investment returns.

Tax treatments can enhance or diminish returns from different types of investments. This is particularly true when investments are held in non-registered accounts and taxes must be paid as investment income is earned and gains are realized.

Everyone wants the best possible after-tax return, and it can be achieved by balancing not only an investment’s risk in relation to potential return but its risk in relation to after-tax return. The reasoning is simple: tax-efficient investing reduces or defers taxes, allowing investors to keep more of their money working for them.

Let’s evaluate the tax treatment for the three basic types of investment returns: interest, capital gains and dividends.

Interest and foreign dividends are taxed as ordinary income in the year they are received (or earned), according to the recipient’s marginal rate of taxation. Depending on where you live in Canada, interest income will be taxed at a marginal rate varying by province, and averages around 52%. Ordinary income is the least tax-efficient investment return.

Capital gains taxes are also calculated according to a person’s marginal tax rate, with the crucial difference that the investor is taxed on only 50% of the gain on an investment. In the example of a 52% marginal tax rate above, the marginal tax rate for capital gains would be 26%. Capital gains are included in income only when they are realized, that is, when an investment is sold.

Capital gains from mutual fund investments receive similar treatment. If a mutual fund realizes a capital gain, the holder receives a distribution, 50% of which is then included in taxable income.

Capital losses also have their uses. While they cannot be used to offset other types of income, they can offset capital gains in the same taxation year. Capital losses can also be carried back to offset gains in the previous three years, or be carried forward indefinitely.

The taxation of dividends is a somewhat more complicated issue. Dividends, the distribution of a portion of a company’s earnings, fall into two classes: eligible and non-eligible. The former are generally those distributed by publicly traded Canadian companies, while the latter are generally paid by private corporations.

The taxation of dividends is complicated by the dividend gross-up and tax-credit mechanism. Dividend taxation is designed to reflect the fact that the corporation paying the dividend has already paid tax on its profits. At the end of the day, for eligible dividends, marginal rates currently range by province, with the average being around 38%. Marginal rates for non-eligible dividends also vary by province, and average around 45%.

Sadly, preferential tax treatment doesn’t extend to dividends from foreign companies. Dividends from abroad are taxed as ordinary income, just like interest.

Rating the returns

So how do interest, capital gains and dividends stack up against each other? Suppose an individual realizes $10,000 on an investment and is in the top marginal tax bracket. Based on the averages outlined above, the following table summarizes what an individual would end up with, depending on the form of the investment gain:

Capital gain = $7,400

Eligible dividend = $6,200

Non-eligible dividend = $5,500

Interest = $4,800

Clearly, a capital gain producing a net return of $7,400 is the best option, given the low tax rates. The other extreme is an interest-bearing investment that leaves the investor with a little less than half of the initial return.

Remember, though, that tax treatment is only one factor in deciding the type of investment returns investors should seek. If they are young and won’t need income for many years, capital gains may be the best bet, because of the ability to defer tax until the gain is realized, and thus the potential for higher returns. Someone who’s older and requires a regular income stream, however, might want to opt for eligible dividends, even though they will be unable to defer receipt of the dividends or the resulting tax bill. And if an investor seeks stability, interest-bearing investments have appeal, despite the fact that they carry the highest tax rate.

Tax efficiency also depends on where investments are held. Generally, investors should hold their most tax-efficient investments in non-registered accounts. This would include stocks liable to generate the greatest capital gains over time, as well as eligible dividend-paying stocks. Alternatively, the least tax-efficient investments – interest-bearing investments, foreign stock or non-eligible dividend-paying stock –should generally be domiciled in registered accounts in order to defer and potentially reduce the eventual tax bill. Talk to your financial advisor to find out what makes the most sense for you.

Some product options

Tax efficiency is just one of the factors to consider in choosing investments. Investors and their advisors should stress the need to balance tax questions against other considerations, as well as pointing out that there are tax-efficient products available. Fidelity offers corporate class mutual fund products that allow investors to invest more tax efficiently. Corporate class funds are held inside a mutual fund corporation and treated as a single entity for tax purposes, providing additional tax benefits for investors. Because corporate class funds can’t distribute higher-taxed interest or foreign income, taxes are minimized or deferred, leaving more money to benefit from compound growth.

Fidelity also offers tax-efficient systematic withdrawal services (Tax-Smart CashFlow™). Fidelity Tax-Smart CashFlow™ provides monthly cash-flow distributions that consist primarily of a return of capital, which isn’t subject to tax. With such plans, taxes are deferred until the investor depletes the initial investment or decides to sell.

Fidelity Tax-Smart CashFlow™ has benefits beyond tax deferment. It can even reduce clawbacks for government benefits such as Old Age Security. Return of capital as a source of cash flow can help preserve and grow investments and, unlike most guaranteed investment certificates or annuities, give investors ready access to their money.

Tax-efficient investing has many layers. It clearly requires some thought on the part of investors, simply because it raises issues that must be seen in relation to other investment factors and objectives. In reconciling these factors, it’s best to work with an advisor, whether it’s for information about the impact of taxation on different types of investment income or products that can help defer and reduce taxes while improving overall returns.