Most investors like a high-income yield, but are you one of them? Do you need monthly income to pay your bills? Is this income earned in a taxable account? If you don’t need the monthly income from investments and you have taxable investment accounts, there is likely a way to lower your taxes.
Let’s start with the basic tax payable on investment income in a taxable account. In Ontario, if you are in the top tax bracket (income of more than $235,675), your marginal tax rate will be the following depending on type of income: Interest income: 53.53 per cent; non-Canadian dividends: 53.53 per cent: ineligible Canadian dividends: 47.74 per cent; eligible Canadian dividends: 39.34 per cent; capital gains: 26.77 per cent; and return of capital: zero per cent.
For greater clarification on a few items, depending on the income of the corporation, many private-company dividends could fall into either eligible or ineligible. For return of capital, it is zero per cent today, but it essentially serves as a deferred capital gain.
The order of the list stays largely the same regardless of your income, except at lower income levels when the eligible Canadian dividend comes in at a lower tax rate than capital gains.
In general, earning steady income from investments makes sense even if we’re talking about lowering investment income in taxable accounts. A study of the S&P 500 going back 80 years found dividends made up between 25 per cent and 75 per cent of total returns depending on the decade. As a result, I am a fan of dividends, but how do you balance this with a lower tax bill?
With this tax knowledge as background, here is a four-step process to balance a desire for income with a lower tax bill.
Allocate appropriately among accounts
Tax-sheltered accounts such as the registered retirement savings plan (RRSP), registered retirement income fund (RRIF), tax-free savings account (TFSA) and registered education savings plan (RESP) are all good places for income investments that may not be taxed. Interest income and United States dividend income (other than in the TFSA) are ideal for these accounts. Even high-dividend investments might be a better fit here.
If you don’t have any taxable accounts (non-registered or corporate), then being strategic about where investments sit is generally not very relevant.
If you do have taxable accounts, it is important to try to allocate the most tax-efficient investments to the accounts that will owe tax. This might mean holding investments in a non-registered or corporate account that generate no income, return of capital or eligible Canadian dividends.
Do you really need monthly or quarterly income from investments?
Are you drawing funds to cover expenses? If so, having steady investment income is likely of value. If not, there isn’t any cash-flow need to earn more investment income. You might even prefer holding stocks with no dividend or zero-coupon bonds.
Even if you require a monthly cash flow, keep in mind you can still sell an investment to raise this cash. From a tax perspective, if it is in a taxable account, this will generate capital gains (or losses), and each dollar will result in a lower tax rate than interest income.
Find more tax-efficient investments
Alphabet Inc., Constellation Software Inc. and many other stocks don’t pay any dividend at all. These types of stocks tend to be growth companies, and lean towards technology, so there are risks, but they will generate no income for tax purposes until you sell them.
Real estate investment trusts (REITS) with high return of capital can provide you with cash flow, but still no tax bill in a current year. Public REITs can have high income, but a sizable return-of-capital component. For example, Slate Grocery REIT has a current yield of 7.4 per cent. In 2021, 58 per cent of its income was return of capital and another 12 per cent was capital gains. There are also many private REIT investments where all income is return of capital.
Consider a home equity line of credit
This strategy is currently out of favour because interest rates are high, but it is often a lower-cost source of cash flow if you would otherwise need to draw funds out of your RRSP, RRIF or corporate account.
Given that it could create a tax bill in the 40-to-50-per-cent range, it might be more tax efficient to get cash with a borrowing cost in the single digits. Of course, low single digits would be better.
This strategy makes the most sense when your funds would otherwise not be taxed for many years. It can be less valuable if you are simply deferring the tax on the income for a year or two.
It can also make sense in some cases for retirees who would otherwise lose some or all their Old Age Security benefits because their taxable income is too high.
Like most things in life, balance and nuance can be important. They say you shouldn’t let the tax tail wag the investing dog. That said, paying meaningfully higher taxes than is necessary should at least get you to pay attention to that wagging tail.
Reproduced from the National Post newspaper article 14th February 2023.
Ted Rechtshaffen, MBA, CFP®, CIM®
President and CEO
(416) 733-3292 x 221