As an investor, it is important to consider the tax efficiency of an investment. Different types of investments are taxed differently by the Canada Revenue Agency (CRA). The tax treatment of an investment can affect your return over the long-term. Holding investments in a tax-sheltered account like your Registered Retirement Savings Plan or Tax-Free Savings Account minimizes tax; interest income held in a non-registered account is taxed at your marginal tax rate, making it the least tax efficient.
Registered Retirement Savings Plans (RRSPs)
A lot of investors make the mistake of thinking an RRSP is a type of investment like a stock or bond. An RRSP is an account that holds different types of investments, such as stocks, bonds, mutual funds and savings accounts. When you contribute to your RRSP, you receive a tax refund because you are receiving a refund of the income tax already been deducted from your pay cheque.
Do not make the mistake of assuming you do not have to pay income tax; with an RRSP, you defer paying income tax but you have to pay it eventually when you withdraw money in retirement. Until then, your investments grow tax-free.
Tax-Free Savings Account (TFSA)
Introduced in 2009, the TFSA is similar to the RRSP, but you do not receive a tax refund from contributions. Similar to your RRSP, your investments grow tax-free inside of the account. Since you contribute with after-tax dollars, you do not have to pay income tax when you eventually withdraw your money.
A TFSA is a lot more flexible than an RRSP. When you withdraw money, your contribution room is not lost; you can contribute the amount withdrawn the following year. For example, if you withdraw $5,000 from your TFSA in March 2016, you can contribute the same $5,000 back on Jan. 1, 2017, or later.
When you hold stock or mutual funds in a non-registered account, you only have to pay tax when you sell your investments.
- If you sell your investment at a profit, you must claim a capital gain.
- If you sell your investment at a loss, you claim a capital loss.
For example, if you bought a stock from XYZ company for $200 and sold it for $400, you pay capital gains on the difference of $200. With capital gains, only 50 percent of your profit is taxable. On capital gains of $200, you only pay income on $100 at your marginal tax rate.
Interest income is the least tax efficient type of investment income.
Examples of interest income include savings accounts, terms deposits and bonds. You are fully taxed on any interest earned. Even if you roll over your interest, you must include it as taxable income. For that reason, consider holding interest income in a tax-sheltered account like your RRSP or TFSA to maximize your tax savings.