July 10, 2014
Over the years it has been interesting to hear how people talk about income taxes.
Taxes affect everyone differently. People are critical about income taxes taking up too much of their earnings. Many recent graduates complain about high taxes while they are struggling to pay off student debt.
Some income earners might invest in risky tax shelter investments to reduce their income tax liability. They will quickly purchase an investment they ordinarily would never have considered, for the sole purpose of lowering their taxes.
To get elected, political parties often position themselves as the party that will keep income tax low. Lower taxes are attractive to voters and often result in the creation or expansion of businesses which may lead to an increase in jobs.
When people are discussing their financial planning and investment objectives, the subject of being more tax-effective comes up frequently. They have the perception that others have strategies to pay less income tax and they want the same advantage.
Often in life it is the simple things that make the most sense. Tax planning is a good example of doing the simple things well in order to reduce your income tax liability. The easiest solution for lowering your taxes is to properly design your investment portfolio. This is an area in which most investors are unsuccessful.
The first part of designing an investment portfolio is determining the asset allocation between stocks and bonds. That decision is a trade-off between how much risk you are comfortable with and how much risk you should take to achieve your objective.
The riskier asset class is stocks. They have a higher degree of volatility than bonds and will most likely have a greater return over the long-term. Assume your decision is to invest 60 percent in stocks and 40 percent in bonds. That is a start but it is only half of the process.
The final part is organizing those investments to be tax effective with the result of achieving the lowest amount of tax to be paid. This is a fairly simple exercise. Stocks pay dividends and have the potential for capital gains.
Dividend income and capital gains offer some favourable tax treatment so they are less costly from a tax perspective than interest income earned from bonds.
Therefore, if you are attempting to shelter investment income from income tax, it is to your advantage to shelter the interest income from your bonds. Sheltering income is easy.
There are no income taxes paid on investments held within a Registered Retirement Savings Plan (RRSP) or a Registered Retirement Income Fund (RRIF).
Therefore, bonds that produce interest income should be held inside a RRSP or RRIF account. When you eventually withdraw money from a RRSP or RRIF it is added to your income and then it is taxed.
Money taken from your Tax-Free Savings Account (TFSA) grows tax-free and there is no income tax paid when those funds are withdrawn. The initial thought might be to also include bonds in a TFSA. Most often and depending on your individual circumstances that is wrong.
A TFSA should be your preferred account in which you hold your best investments. Those would be the investments that will make you the most money over time. That will most certainly be stocks.
You should own stocks inside your TFSA because they grow tax-free and then when withdrawn they are not subject to tax.
Each investment portfolio has its own characteristics based on your needs. You will pay less income tax if you are holding the right types of investments in the right account.
We recommend you review your investment portfolio to make sure the various types of investments are in the correct accounts. A little simple tax planning can significantly reduce your income tax liability.