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By Steve Lowrie, CFA
Special to Financial Independence Hub
I would be remiss if I didn’t dedicate at least one post in my “Play It Again, Steve” series to everyone’s least favourite, but still significant topic: taxes.
It’s a good thing there’s no tax on writing about tax planning; if there were, I would surely owe a lot.
Here are six timeless techniques for reducing your lifetime tax load:
1. Fill up your tax-sheltered investment accounts.
Taxes primarily exist to raise money for government operations, but they also are often structured to encourage us to spend and save in particular ways. For example, there are:
- Tax-favoured Registered Education Savings Plans (RESPs) that make it easier to save for your kids’ education,
- Tax-Free Savings Accounts (TFSAs) to set aside money tax-free throughout your lifetime,
- Registered Retirement Savings Plans (RRSPs) to reduce taxes and save for future retirement lifestyle needs, and
- new for 2023, the tax-free First Home Savings Account (FHSA).
If you’re saving anyway, you might as well take advantage of any available tax breaks for doing so. Each tax-sheltered, or “registered” account comes with different rules on whether the money goes in pre- or post-tax, and whether it comes back out as taxable or tax-free income. But all of them share a powerful, often overlooked advantage: Investments in all registered accounts grow tax-free.
So, fill up those registered accounts. Also, be sure to invest any of it you’re not going to need for a decade or more. The snowball effect of tax-sheltered investing should help you accumulate significantly more after-tax wealth than if it’s just sitting in cash.
2. Invest tax efficiently in and among your registered and taxable accounts.
There are endless ways to invest more tax-efficiently; here are a few of the greatest hits:
How you invest: Since you only incur taxes when you sell a holding, an obvious rule of thumb is to avoid unnecessary taxable trading. Build a durable portfolio you can stick with through thick and thin, and avoid chasing hot and cold stock picks and market conditions.
With whom you invest: Especially in your taxable accounts, avoid funds whose managers are actively picking stocks or timing the market. You won’t directly see their extra, unnecessary trades. But they’ll show up at tax time in the form of taxable capital gain distributions to unit holders: i.e., you. Worse, you could end up owing taxes on those invisible gains, whether the fund goes up or down in value. There are few more unpleasant surprises for an investor than a big, year-end tax bill on a fund that’s lost value.
Where you invest (asset location): Hold your relatively tax-inefficient assets (such as bonds and REITs) in tax-sheltered accounts, where the inefficiencies don’t matter as much. Hold your relatively tax-efficient assets (such as broad stock funds) in taxable accounts.
3. Remember, not all tax rates are the same. Aim for the less costly ones.
For personal taxable accounts and investment holdcos, some taxes cost less than others. Your most tax-efficient investing income comes in the form of capital gains, since they are taxed at lower rates than other sources such as interest or dividends. This, combined with asset location considerations, is another reason to avoid loading up on dividend stocks as a strategy for generating an income stream in retirement.
Don’t believe me? Consider these 2023 combined tax rates for Ontario:
| Taxable Income Source | 2023 Combined Tax Rate |
|---|---|
| Interest and other income | 53.53% |
| Eligible dividends (mostly Cdn. companies) | 39.34% |
| Capital gains | 26.76% |
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