While registered retirement savings plans (RRSPs) and tax-free savings accounts (TFSAs) are very useful tax shelters – tax deferred and tax free, respectively – affluent investors soon find themselves out of contribution room and forced to invest in non-registered or taxable plans.
With the current focus on high-yielding dividend-paying stocks, investors still working and building wealth may find it counterproductive to receive non-registered dividend income each year and be forced to pay tax on it.
Dividends from U.S. stocks are taxed at the top marginal tax rate, just like interest income or earned income, which is why the first place to put them is inside RRSPs. TFSAs are not quite so attractive for holding U.S. dividends because despite being called “tax free,” Canadian recipients of such dividends will lose 15% to the foreign withholding tax. This does not occur in RRSPs because of the tax treaty between Canada and the U.S. So all things being equal, I’d put U.S. dividends in RRSPs, Canadian dividends in TFSAs and interest-bearing investments in either TFSAs or RRSPs.
If you’ve used up all your tax-sheltered room and prefer fixed income, there’s not much you can do to avoid the high tax on interest income. Those willing to take on a bit more risk can invest in preferred shares, which behave a bit like bonds but whose payouts qualify for the dividend tax credit. Tax on Canadian dividends (including preferred shares) is roughly half the level of tax on interest income.
Still, those who have employment income and who are still accumulating wealth may find it frustrating to pay tax on non-registered dividend income when they’re not actually spending the proceeds, but merely reinvesting it into more shares. If your focus is so-called total return, you don’t fret so much about generating regular dividend income and may be happier to shoot for capital gains in your taxable plans. The beauty of capital gains is that you don’t have to pay tax every year, as is the case with dividends or interest. The trick with capital gains is to let the securities rise in value without ever taking profits along the way. As long as you only have a “paper” profit (i.e., an unrealized gain), there are no immediate tax consequences. Later in life, perhaps in retirement when you’re in a lower tax bracket, you can choose to trigger gains and pay tax, hopefully at a lower rate. Compared with dividends, capital gains give you the chance to defer the tax event far into the future.
Unfortunately, if you invest in plain vanilla Canadian ETFs tracking the major indexes like the TSX, you’re going to get a lot of taxable dividend income. New developments in ETFs can help. A number of special ETFs do not pay out quarterly dividend income – you may not like that if you’re already retired but if you’re still working and ready to build wealth, this feature means the gains manifest as a rise in the net asset value of the units instead of generating taxable dividend income. As long as you hold the ETFs rather than sell them, you have an indefinite tax deferral.
Jonathan Chevreau is editor of MoneySense magazine and author of Findependence Day, available at www.findependenceday.com.