Tax reduction is not the primary criterion for choosing investments but it certainly is an important one.
Tax-exempt or tax- deferred investing refers to the tax status of the earnings on an investment. Although these terms sound similar, they are quite different. Understanding how taxes affect different investments will help you choose the investments that are best for you.
With a tax-deferred investment, taxes are not owed on the investment until it is sold. For example, a non-registered equity investment will attract little or no tax until the investment is sold. However, not many investors buy and hold an individual security or mutual fund in a non-registered account for 20 or 30 years.
The RRSP
Advantage
One of the best ways to save for retirement is through tax-deferred investments such as Registered Retirement Savings Plans (RRSPs).
They allow taxpayers to minimize their tax burden by making tax-deductible contributions (money added to an investment), subject to the individual’s RRSP deduction limit, which is called your contribution room. However, contributions to employer- sponsored retirement plans and some RRSPs can be made with pre-tax dollars and is taken directly from your pay cheque. This allows you to defer taxes until you start making withdrawals. This allows you to keep the money that would have been paid in taxes at the time it was earned, leaving a greater amount available for tax-deferred investing.
While investing in RRSPs is a tax-deferral strategy, any withdrawals from the plan are subject to immediate withholding tax, which ranges from 10 per cent to 30 per cent of the amount withdrawn.
Your financial institution withholds this tax, which is based on your residency and the amount you withdraw.
Keep in mind, the amount you withdraw is included in your taxable income for the year, so depending on your marginal tax rate, you may be subject to additional tax at year-end.
Complicating the matter is a requirement to convert your RRSP into a Retirement Income Fund (RRIF) at the end of the year in which you turn 71 years old.
This forces you to make taxable withdrawals from the plan, even if you don’t have an immediate need for the money.
Tax-Exempt
Investing
One way to pay less income tax is to invest after-tax dollars in a tax-exempt plan which provides you, the investor, with immunity from the requirement of paying taxes in the future.
The Tax-Free Savings Account (TFSA) is a new hybrid savings account, which became available January 1, 2009.
TFSAs allow Canadians to save and invest on a tax-exempt basis for any financial goal, such as retirement, a house, a car or a vacation. While contributions are not tax- deductible, investment earnings, and more importantly, withdrawals are “exempt from taxation.”
Unfortunately, the biggest drawback is the limited contribution room of $5,000 per year. In addition there are other, lesser-known strategies that can affect your tax situation. Life insurance, for example, can be structured as a tax-efficient savings vehicle.
Annuities and insured annuities can also provide tax relief to retirees seeking income, and can be used to restore certain clawed back government benefits.
Jim Grant, CFP (Certified Financial Planner) is a Financial Advisor with Raymond James Ltd (RJL). The views of the author do not necessarily reflect those of RJL. This article is for information only. Securities are offered through Raymond James Ltd., member CIPF. Financial planning and insurance are offered through Raymond James Financial Planning Ltd., which is not a member CIPF. For more information feel free to call Jim at 250-594-1100, or e-mail at jim.grant@raymondjames.ca. and/or visit www.jimgrant.ca.
