Did you know that not all your income are taxed equally? Your job’s income, interest income, foreign dividends, and RRSP/RRIF withdrawals are all taxed at the highest rate — your marginal income tax rate.
Other income, such as eligible dividends, capital gains, and the return of capital portion of distributions, are taxed more favourably.
However, in no way does it mean that you shouldn’t invest for interest income or foreign dividends. Nor does it mean that you should avoid investing in RRSPs. Investors should always invest for their needs and what they’re comfortable in.
Today, we’ll cover some ways to lower your taxes — primarily by investing in the right accounts.
How to reduce your taxes from the highest-taxed group?
Your job’s income, interest income, foreign dividends, and RRSP/RRIF withdrawals are all taxed at your marginal tax rate — the highest rate. Here are some ways to reduce those taxes.
Contribute to an RRSP
If you’re in a high tax bracket, you can contribute to an RRSP to lower your tax bracket and income tax for the year. Remember that any refunds you receive from contribution to an RRSP are essentially a loan from the government because when you withdraw from the account, you’ll have to pay taxes at the marginal rate.
Shelter your interest income
Interest income from savings accounts, bonds, or elsewhere should be considered to be sheltered in a TFSA or RRSP.
Invest for foreign dividends in the right accounts
If you invest for foreign dividends, chances are the home country of the company deducts a withholding tax on its dividend. The amount of the withholding depends on the tax treaty between that country and your country.
Here’s a list of foreign dividend companies with no withholding tax on their dividends.
If you invest in a U.S. corporation, such as Pfizer Inc. (NYSE:PFE), which offers a qualified yield of 3.7%, there will be a 15% withholding tax on its dividend. The only place to get the full dividend is by investing its shares in an RRSP.
Here are some scenarios using Pfizer as an example
If you invest Pfizer in a taxable (non-registered) account, you get a 15% withholding tax on the dividend and ultimately pay the marginal tax rate on the foreign dividend.
If you invest its shares in an RRSP/RRIF, you get the full dividend.
If you invest its shares in a TFSA, you get a 15% withholding tax on the dividend. The remaining dividend and any price appreciation are sheltered from taxes.
RRSP/RRIF withdrawals are taxed at the marginal tax rate. Depending on how much income you’ll earn for the year, it may be better to take out the minimum required amount or more.
If you don’t need the income from your RRIF but you’re required to take out a minimum amount, remember that you can transfer in-kind to a taxable or TFSA account without having to sell your shares.
If you invest Canadian dividend stocks in your RRSP, consider taking them out at the start of the year (come withdrawal time) to reduce taxes, since the eligible dividends are favourably taxed in a taxable account. Additionally, share prices tend to go higher over the long term.
I’ve also heard from a near-retiree who strategized to transfer in-kind from a retirement account to their taxable account during a market crash to save taxes.
Eligible dividends: favourably taxed
Eligible dividends from Canadian companies are taxed at a favourable rate in a taxable account. Popular stocks in this category include the Canadian banks, such as Royal Bank of Canada (TSX:RY)(NYSE:RY), the utilities, such as Fortis Inc. (TSX:FTS)(NYSE:FTS), and the telecoms, such as BCE Inc. (TSX:BCE)(NYSE:BCE). They offer yields of 3.5-4.9% currently.
Capital gains: most favourably taxed
The general rule is that if you buy a stock for at least 30 days, it’ll be counted as a long-term capital gain. I believe the rule resets if you buy more shares subsequently.
Long-term capital gains are the most favourably taxed. Only 50% of the gains are taxed at your marginal tax rate.
If you never sell and let your shares grow perpetually, essentially, your gains are tax-deferred indefinitely.
Remember that reinvested distributions increase your adjusted cost basis and must be tracked in a taxable account.
Return of capital: most favourably taxed
Sometimes there’s a portion of a distribution from mutual funds or real estate investment trusts (REITs) called return of capital (ROC).
ROC is income that is tax-deferred. It reduces your adjusted cost basis and counts towards boosting future capital gains (or reducing future capital loss) until your adjusted cost basis turns negative.
Investors can look for REITs with a history of high return of capital (hoping that they’ll maintain that trend) to generate a nice stream of tax-deferred income in a taxable account.
Retail investors should avoid buying U.S. master limited partnerships (MLP) despite their seemingly attractive yields because you’ll be liable to file to the IRS to pay federal and potentially multiple state taxes for every state the partnership may operate in.
Always check with the investor relations of the company or a qualified financial advisor if you’re not sure!
Final tax tip
If you’re between 65 and 71 years old, you may be eligible for the pension income tax credit.
Ultimately, investors should look at their diversified portfolio and decide where best to put their investments to save the most taxes. It’s not how much you earn but how much you keep.
It would probably be wise to sit down with a qualified accountant, such as a CPA, who has experience with tax planning and decide on the best tax-efficient investing and withdrawal strategy for you.
If you like what you've just read, consider subscribing via the "Subscribe Here" form at the top right so that you will receive an email notification when I publish a new article.Disclosure: At the time of writing, I own shares of Pfizer in my RRSP and Fortis in my taxable account.
Disclaimer: I am not a certified financial advisor. This article is for educational purposes, so consult a financial advisor and or tax professional if necessary before making any investment decisions.
Get Exclusive Articles from me on Seeking Alpha
- Access my portfolio of high-quality U.S. and Canadian dividend stocks.
- Real-time updates of when I buy or sell from this portfolio.
- Get best ideas of the top 3 dividend stocks from my watchlist. Updated each month.