Everyone is aware of their tax bracket. It affects us every spring when we calculate how much we have to pay to Ottawa and our provincial government. However, your tax bracket also has implications for your investment strategy. Here are a few items to consider.
Note: Examples below are based on 2013 tax rates/tax brackets using Ontario rates for the provincial portion.
- We have all been brought up to think that we should put away money in RRSPs and claim them on our annual tax filing. However, perhaps you should be investing in a TFSA instead. If you are in a lower tax bracket today, and expect to be in a higher tax bracket in a few years, invest first in a TFSA today and save your RRSP contribution deduction until you are in a higher tax bracket and your tax deduction will be worth more. You can contribute to your RRSP this year, but postpone your deduction until next year if you expect to receive a salary increase or a bonus cheque in the following year that will put you in a higher tax bracket.
- Investing in US dividend generating securities in your TFSA is generally not advised because of the US withholding tax of 30% on the dividends. However, you can file a W-8Ben which will reduce your withholding tax to 15%. Then if you expect to be in a tax bracket higher than 35% in retirement, it is advised to put the US equity investment into your TFSA (assumes holding for 20 years and a 5% annual earnings). Note, historically the US S&P500 has outperformed the Cdn S&P/TSX which might be the primary reason to consider including US investments in your portfolio.
- Capital Gains and eligible dividends are generally understood to have the lowest tax rates in Canada. But which one is lowest? There are dramatic differences between the two depending on what your taxable income/marginal tax rate is. A general rule of thumb: if you are in a lower tax bracket, dividends will have a tax advantage over capital gains; and if you are in a higher tax bracket, capital gains will have a better tax treatment. For example: If you are in the 24% tax bracket (taxable income between $39,724 and $43,561) eligible dividends will have the lower tax rate (3.77% vs 12.075%). If you are in the 43% tax bracket, (taxable income between $87,124 and $135,054), capital gains will have the lower tax rate (21.705% vs 25.4%).
Note: the point at which capital gains are taxed at a lower rate than eligible dividends varies quite a bit by province because each province has a different dividend tax credit as well as different tax brackets. At the extremes, Alberta always favours dividends over capital gains from a tax point of view at every tax bracket; Manitoba, Quebec and Nova Scotia have some of the lowest taxable income levels at which point capital gains are favoured over dividends.
Tax Strategy is only one of many things that should be considered when formulating your investment strategy. Your goals, lifestyle needs, family considerations, risk tolerance and cash flow all need to be considered. Having a comprehensive financial plan which considers all of these factors, both today, 10 years from now, and in your retirement is critical to making smart investment decisions today for your long-term financial success. At TriDelta we do our best to ensure that your investments are being managed tax efficiently for your personal circumstances.
Posted by Gail Cosman, Senior Wealth Advisor, Tridelta Financial