How do I… reduce tax on investment income

Tax planning for investment income is often overlooked as a strategy for improving your portfolio returns. But saving money can be just as important as growing it. By structuring your portfolio to take advantage of key strategies and tax-efficient investments, you maximize how much of your investment earnings stay in your pocket – rather than the government’s.

What is investment income and how is it taxed? 

Investment income refers to the money you earn from investments, like stocks, bonds, or real estate. When you invest your money, it has the potential to grow over time. And when that happens, you make a profit. That profit is called investment income and there are different types out there. These include:

Capital gains

This is when you buy something, like a stock or piece of art, and sell it later for more money. The difference between what you paid for it and what you sold it for is your capital gain.

Dividends

These are payments companies give to their investors (known as shareholders). How much you get is based on the company’s profits.

Interest

This is money you earn in return for using certain types of saving and investment solutions. For example, a savings account or term deposit.

But here's the thing – when you make money from your investments, the government wants its share too. That's where taxes come in. The amount you have to pay depends on a few factors. One of the most important is the type of investment you have. Each one is taxed differently. For example, interest income is taxed at your marginal tax rate, while capital gains are taxed on 50% of the total “gain” (i.e. the profit you make from the investment).

But don't worry, there are key strategies and tax-efficient investments you can use to keep more of your hard-earned investment income.

Two tax-efficient investments to explore

As mentioned, not all investment income is taxed equally. So it pays to be strategic in your investment decisions. By choosing tax-efficient investments, you can save money and maximize the returns you earn. Here are a couple of options:

Dividend income

In Canada, the government wants to encourage people to invest in Canadian companies, so they offer the Federal Dividend Tax Credit. This credit reduces the tax you owe on Canadian dividend income. As a result, Canadian dividend-paying stocks are often considered valuable, tax-efficient investments to include in your portfolio.

Corporate class mutual funds*

Another tax-efficient investment you may want to consider is corporate class mutual funds. That’s because they’re structured in a way that offers strong tax advantages and flexibility:

• Tax-efficient growth – This type of mutual fund is set up as a company, which can help lower or delay the taxes you owe compared to a mutual fund trust. That’s because trusts are often required to distribute income each year, triggering immediate taxes for investors.

• Tax-efficient cash flow – With some corporate class mutual funds, you can get back the money you originally put in (your capital) before taking out the money you earned. This can help you delay paying taxes on earnings until you owe less.

Every person is different and so is their portfolio. Whether these tax-efficient investments or others make sense for you will really depend on your goals, comfort with risk and financial situation. If you want help figuring out the best combination of investments for you, book a chat with one of our experienced advisors. They’ll be happy to help find a portfolio that fits you and your goals.

How to invest to reduce income tax

Tax-efficient investments aren’t the only way to save on tax. There are also a number of strategies you can use:

Maximize TFSA & RRSP contributions

The Registered Retirement Savings Plan (RRSP) and Tax-Free Savings Account (TFSA) both offer fantastic tax saving opportunities. You can hold all kinds of investments in them – mutual funds, term deposits, stocks and bonds, even savings accounts  – and they come with big tax benefits:

• RRSPs – Contributions to this registered plan are tax deductible. This means that when you contribute to your RRSP, you can subtract that amount from your taxable income, reducing how much you owe. Any interest or income you earn from investments in an RRSP are also tax free until you withdraw the money, which helps your savings grow faster.

• TFSAs – TFSAs also offer tax-free investment growth with some key differences. Contributions aren’t tax deductible the way they are with the RRSP. But interest and income earned in this account stay tax free even when the money is withdrawn. So you’re never taxed on them.

As a result, it pays to maximize these registered plans. However, they do have contribution limits, so it's important to track how much you put in to avoid penalties.