|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 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
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
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
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.