22. Optimize your investments by plan type

Transcript:

Evan Neufeld: Hello, and welcome back to the Canadian Money Roadmap podcast. I'm your host, Evan Neufeld.  Today's episode is the third part of my summer series where I'll have more frequent, but shorter episodes on the topics of investing smarter and reducing taxes. 

Joining me today again is my colleague and Certified Financial Planner, Steven Guenther. Steven, thanks for joining me. Okay Steven, when we talk about investing, people are wanting to make money. Making money is all about the rate of return that you get, but returns aren't just about how much you make. It's how much you're able to keep after taxes. So now this is kind of bridging that investing smarter and reducing taxes concept. So how can we do that?  

Steven Guenther: Behold the tax man is coming. You've got the tax man who wants a cut. So naturally what you keep is always after tax.  We call it after tax dollars or after-tax returns. A good example of this is the Tax-free savings account. Your listeners may be familiar with your tax free savings account podcast. 

Evan Neufeld: Or as I've referred to it as a tax-free investment account or tax-free retirement account. 

Steven Guenther: So that's exactly as it sounds, the returns you earn are a hundred percent tax-free.  So if you make 6% in your investment, you keep 6%. Not so if you're investing in  what's called a non-registered account, there's different synonyms for this, but non-registered is one of them, Open is another and a cash account is another. Those three things all mean the same thing it just effectively means It's not part of a government tax advantage program, like an RRSP, a pension or a tax-free savings account.  

Evan Neufeld: Yeah. A non-registered or an open account kind of goes to the CRA or the Canada revenue agency default of, Hey if you make a dollar, we're going to take some.  

Steven Guenther: So if you're investing there, tax is a factor.  So you need to be thoughtful with how you organize your portfolio in such a way that you limit taxes across the board. And the reason why this is even a factor is because not all types of investment income are taxed at the same rate. 

Evan Neufeld: So when you have a rate of return, X percent that could be a combination of a variety of different types of investment income.  Is that correct?  

Steven Guenther: Most people are familiar with interest. You know, when you have a savings account in the bank, you earn interest. But a better word of describing investment income is growth and growth, it's like the umbrella term for interest. And then there's two others. There's something called dividends and there's capital gains. So there's interest, dividends and capital gains that comprise somebody's total growth in an investment.  

Evan Neufeld: Let me break those down for you quickly. So interest is typically earned in a place like a savings account, but it's also earned when you own things like bonds or other types of fixed income. 

So that broader category, it pays a set amount of interest all the time. Now that can fluctuate a little bit, but that's how you typically make money from fixed income, from savings accounts and from GICs. Then from there, dividends are a portion of a company's profits that are distributed back to owners of that company or shareholders. 

So say for example, Apple's the biggest company in the world right now. They make a ton of money and a ton of profit. And so every quarter, I think they have a small dividend that they pay out. So if you own shares in apple, you're going to get paid a little bit of cash, and that's just sharing in the profits with you. 

Then finally capital gains is that last type of investment income that you can earn and that is just something appreciating in value. So again, let's use that apple stock. So it would say you bought a share of apple for a hundred bucks. Now it's worth $200. Well, now you have a hundred dollars worth of capital gains there in that share. 

Steven Guenther: And each one of those will be realized in different ways. And so this is important because especially for the last one, capital gains are typically only realized when you sell an asset. So the apple stock is now valued at 200, you sell the stock. You now have a hundred dollars of realized capital gains.  Same goes with dividends, sometimes dividends won't be paid by that company.  If they don't pay any, of course you're not paying any tax on any. So you don't have to consider that. And then interest is the last one. So interest is always tax when it's received. So if you get $2 in interest, you have to add $2 to your investment income on your tax return. So you've got three categories that are earned in different ways, but the more important part is that they're taxed in different ways. 

So interest is like employment income. It's taxed a hundred percent. So if you have a 2% savings account, you have a hundred thousand dollars in, it goes up by $2,000. Over the year, you add $2,000 to your tax return as investment income. Now, if that same 2% was in the form of dividends or in capital gains, you're not adding all of it to your tax return. 

Those are both more tax efficient sources of growth. And so we want to prioritize dividends and capital gains over interest in a general sense. 

Evan Neufeld: Because you'll pay less tax on each of them.  

Steven Guenther: So you'll keep more of the 2%. You might keep 20% more, 30% more in exchange or in comparison to interest. 

Evan Neufeld: Okay. Now let's break down some of how each of those different plan types treat tax as well. So we talked about TFSAs, RRSPs and non-registered accounts. Let's stick with those three. There's a few others, but let's stick with those three. So TFSA, this one is the no brainer, the easiest one to understand, easiest one to implement. Tax-free applies to all types. So there is no tax on interest or there's no tax on dividends that you earn and there's no tax on capital gains, any questions? Pretty straightforward. Okay, great.  

Then RRSPs, these are an interesting one because you can own the same types of investments in TFSAs, RRSPs and non-registered. But with an RRSP, because you get that tax credit when you put the money in, they want tax on the way out. So in the meantime is where you have the advantage because you don't have to pay annual tax on interest or dividends received. You only pay tax when you take the money out of the plan. So we call this a tax deferred plan. Okay. But, when you take the money out, it doesn't matter if it was your original contributions, interest, dividends, or capital gains, it's all treated the same way. It's all taxed and we call your marginal rate. And if you go back and listen to my tax basics episode, you'll know that if you make more income, you'll pay a higher rate of tax. So if you're making withdrawals from your RRSP, the more you take out, the more tax they're going to pay.  But it's even across the board, regardless of what type of income you're taking out. 

Then the final plan type of non-registered. Steven, can you explain how that one works?  

Steven Guenther: This is the most complex, so thanks. So the basic rule is as income is received, so it is taxed. The exact same as employment income. You earn a paycheck, you have to claim that income in that given tax year. So the same goes for the three types of investment income that we've described. 

So if you receive interest that year, you add it onto the tax return. You received dividends, you add it onto the tax return. Same with realized capital gains, you add it on.  

Evan Neufeld: Let's compare capital gains and interest though. So say I had a hundred dollars in realized capital gains and a hundred dollars of interest. Is that the same thing? 

Steven Guenther: No. So you got a 100% taxable interest, whereas in Canada, there's something called the capital gains inclusion rate, which is a mouthful, but what it speaks to is how much of your realized capital gain becomes taxable in the year that it's realized. So a hundred dollars of realized capital gains in a given tax year only amounts to 50% taxable. So only $50 would be taxable in the year that gain was realized. So it's 50% of the tax you would have paid on your interest, which means you keep more of your money, assuming that you earn the same return in interest or capital gains. You will keep more money in the capital gain type of investment income versus interest. 

Evan Neufeld: Right. Okay. So let's just put this in really basic terms. Then if you have a hundred dollars of interest, you have a hundred dollars at realized capital gains. Capital gains are 50% off they're on sale. Perfect. Okay. So to try to simplify this a little bit more, if you think of bonds paying interest and stocks growing via capital gains. The types of growth that you get out of both investments are different and the types of tax you pay on different plan types are different. 

So is there a way that we can match these up to have a really effective portfolio for both investing smarter and reducing taxes?  

Steven Guenther: Absolutely. So this is plan based asset allocation. So let's just assume everything else being equal you would rather hold your least efficient assets in your RRSP, because when you withdraw, the money does not differentiate what type of growth it was. It is taxed the same, it's 100% taxable, wether it was interest, capital gains, dividends it doesn't matter. 

Evan Neufeld: So if I have capital gains in the RRSP, I thought I got it 50% off, but no, you don't because, any money you take out of the plan is a 100% taxable.  

Steven Guenther: The opposite is true if you look at a non-registered account, that is where you see the full difference in the taxation of the investment growth.  So naturally you would want to hold more stocks in a non-registered account, then bonds all else being equal. Now there's a lot of decisions that come into asset allocation, but assuming all plans are going to be invested the exact same way or for the exact same goal. And you wanted to let's say have a split of 50% stocks, 50% bonds you'd want to put as much of that 50% in bonds in the RRSP component of your overall portfolio and as much of the stocks in the non-registered part of your portfolio, thus achieving the highest level of after-tax return, after all is said and done. 

Evan Neufeld:  That's, that's a lot of great content, Steven. The main point to take away here is that there are different types of income earned from investments. Different plan types will tax things differently.  But we'll come to some more specifics later on this summer. 

Thanks for joining me today on the Canadian money roadmap podcast. If you enjoyed today's episode, I'd really appreciate if you left me a review on apple podcasts with your biggest takeaway. If you have questions or ideas for topics you'd like me to discuss on future episodes, please reach out via my contact info in the show notes. 

This podcast is intended to be educational in nature, and you should always consult your financial, tax and legal advisors before making changes to your financial plan. Any rates of return discussed are historical or hypothetical and are to be used for educational purposes only. Evan Neufeld is a Qualified Associate Financial Planner and registered investment fund advisor. Mutual funds are provided through Sterling Mutuals Inc.