TAXATION - Smart Investing

The profits that you make on your investments are subject to different tax treatments depending on the type of income that you receive from the particular investment.

Should you hold investments inside or outside of your RRSP? While there are tax advantages to holding investments that result in capital gains and dividends outside of your RRSP, interest-bearing investments may be best held in your RRSP as the interest income is 100% taxable either way.

If you are not aware of the tax treatment of the income from your various investments, you could be losing some tax advantages.

Capital Gains

At the current capital gains inclusion rate of 50%, only one-half of any capital gains you make outside of your RRSP is subject to tax. This portion of the gain is included in your income and taxed in the year of the sale. However, if you were to realize that capital gain within your RRSP, the entire gain would be taxable at the time that you withdraw it from your RRSP.

For example, say that you invested $10,000 in the equity market outside of your RRSP and had the good fortune to later sell at $15,000. At the current capital gains inclusion rate of 50%, only $2,500 of this income (50% of $5,000) would be subject to income tax in the year of sale.

If you sheltered the investment in your RRSP, you would defer the tax until such time that you made withdrawals from your plan. However, the full amount of $5,000 would be subject to income tax at the time that you withdraw it. Of course, you must weigh the advantage of reinvesting the entire $5,000 within your RRSP and continuing to defer the taxes on the further income and capital gains.

As you do not have to convert your RRSP until age 69, this tax disadvantage could be offset as the tax on this investment income is deferred until you start receiving it at age 70. Consider also that you may be in a lower tax bracket in your retirement years than you are now.

Dividend Income

Dividends are also subject to preferential tax rates so your after-tax return is increased when the dividends are received outside of your RRSP. Dividends that you receive from a Canadian corporation are taxed at a lower rate than interest income because of the dividend tax credit. The dividend tax credit is available to taxpayers since the corporation has already paid tax on the earnings that it has distributed as dividends to its investors.

Dividend income received from foreign companies is taxed at the same tax rates as interest income, but a foreign tax credit is available for any foreign taxes that have been withheld.

If the dividends from Canadian and foreign corporations are received within your RRSP, you will defer the tax on this income. However, at the time you withdraw this money, it will be fully taxable as income and you will not have the tax advantage of applying the dividend tax credit or the foreign tax credit.

Mutual Funds

If you purchase mutual funds outside of an RRSP, the taxation of this investment depends on whether you acquire a share of a mutual fund corporation or a unit of a mutual fund trust. With both, you may receive distributions during the year. With a mutual fund corporation, these distributions are either capital gains dividends, which are treated the same as capital gains with only 50% included in income, or taxable dividends.

A mutual fund trust allocates its income to the unitholders who then report the income, which may include capital gains, dividends, foreign income and other income.

When you sell the unit of a mutual fund trust or the shares of the mutual fund corporation, you may realize a capital gain on the disposition. Also, as discussed above, the beneficial tax treatment of capital gains and dividends is lost if they are received by an RRSP.

Interest Income

Interest income is fully taxable in the year in which it is received. For example, GICs and bonds produce interest income. Of course, if the GIC or bond is held within your RRSP, the tax on the interest earned is deferred until such time as you withdraw it.

Investments in your RRSP

Generally, your purpose for holding investments in your RRSP is to provide long-term returns so that you can augment your retirement income in the future. This allows the tax-deferred income to grow within the RRSP. Of course, your RRSP holdings must be invested in qualified investments, which fortunately include a wide range of investment vehicles. When you withdraw the funds, however, keep in mind this income is fully taxable at your marginal rate at that time.

Since various types of investment income receive different tax treatments, you should consider whether you or your RRSP should hold the different components of your asset mix. You should talk to your accountant and your investment advisor about the potential impact of your investment strategies on your income tax position. Keep in mind that each investor’s situation is unique as the after-tax return on investments varies according to the individual’s income level and marginal tax rate as well as any other tax benefits that may be available.