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Article Library

Tax-effieient fixed-income investing

Thursday, July 22, 2010


As a financial advisor (and investor), I am always searching for methods of saving my clients income tax through every legal means possible. There are three basic methods of taxation, and how you get taxed depends on the investment vehicle you use.

In this article, I’ll look tax-efficient investing with a focus on fixed-income in open, or non-registered, accounts. (All types of investment income are taxed dollar for dollar when they are redeemed from a registered plan like a Registered Retirement Savings Plan.) So here’s an overview to help you make investment choices that are tax-preferred.

Capital gains

Capital gains arise when you purchase an investment (stock or equity mutual fund) on which you realize a gain on any increase in value. For example, suppose you bought an equity mutual fund for $5,000 in 2008, when markets were at a low. Today, you redeem your investment for $9,000.Your profit is $4,000, and your taxable gain is 50% of $4,000, or $2,000, which is then taken into income and taxed at your top marginal rate. This is a good tax-efficient method of investing. Only the Tax Free Savings Account (TFSA) is better (no tax at all is applicable on growth in the TFSA or on withdrawals).

The main drawback with capital gains is that typically, investments generating the best capital gains are equity-based, which may mean more volatility than you’d like, or may require a longer time horizon.

Dividends

Dividends also fall under the category of a tax-favored investment, because of federal and provincial dividend tax credits that reduce the effective personal tax rate on dividends. Depending on which province you live in, dividends aren’t quite as good for income tax purposes as capital gains, but they’re in the same ballpark.

Interest income

Most well-balanced portfolios include fixed-income investments, such as government or corporate bonds or bond funds, guaranteed investment certificates (GICs), Canada Savings Bonds, and mortgage funds.

These investments typically decline far less than equities in a market correction and continue to pay interest income even while markets are down, thus helping to smooth out overall portfolio volatility and mitigate risk.

An RRSP is a perfect place to earn interest income, because all investments within an RRSP are taxed the same. Outside an RRSP, however, fixed-income returns are normally lower (by anywhere from one to six percentage points), while tax and inflation further reduce your net after-tax return even more.

Corporate Class funds

To add more fixed income to your open account in a tax-advantaged way, look into corporate (or capital) class bond mutual funds. This wonderful, innovative investment vehicle essentially makes what would be interest income into capital gains income through a corporate structure. This way, you get diversified, professionally managed fixed-income portfolio, and you can keep your conservative investments in an unregistered account without losing most of the gains through taxation and inflation. (For more on corporate class funds, see David West’s recent article in the Fund Library.)

By having the same investment within a corporate class structure, your net return can increase by over 40% if you are in the upper income tax brackets.

Many mutual fund companies offer corporate class funds. This is a huge advantage over exchange-traded index bond funds (ETFs) that is rarely mentioned. Many advisors are keen to jump on the ETF bandwagon and there are undeniable fee advantages over mutual funds. But often it isn’t a clear-cut apples-to-apples comparison, owing to the active management offered by many bond mutual funds, and the clear tax advantages of bond mutual funds in a corporate class structure.

What goes in your pocket after-tax is a big part of your overall portfolio return. It only makes sense to pay attention to tax efficiency when planning your investment portfolio.

 

Generic Mutual Fund Disclaimer

Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the simplified prospectus before investing. Mutual funds are not guaranteed and are not covered by the Canada Deposit Insurance Corporation or by any other government deposit insurer. There can be no assurances that the fund will be able to maintain its net asset value per security at a constant amount or that the full amount of your investment in the fund will be returned to you. Fund values change frequently and past performance may not be repeated.

Personal Opinions & Recommendations Disclaimer

The foregoing is for general information purposes only and is the opinion of the writer. This information is not intended to provide specific personalized advice including, without limitation, investment, financial, legal, accounting or tax advice. However, please call the author to discuss your particular circumstances.


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