Preparing for Retirement? Focus on Tax Efficiency

The final years leading up to retirement represent the “home stretch” of your retirement savings strategy. These are also likely to be your peak earning years, as you near the top of your career path. 

But higher earnings attract higher tax rates. If your children are self-sufficient and your home is almost or completely paid off, income taxes are likely to be one of your largest expenses. By paying as little tax as necessary, however, you may be able to increase your after-tax cash flow. The money that doesn’t go to the government can be redirected to your retirement savings. 

Take a portfolio approach

With investing, it’s always important to take a portfolio approach.

This means you need to look at all the investments — both registered (RRSP, TFSA for example) and non-registered — held by you and your spouse, if applicable, as one integrated “portfolio.” By examining the big picture you can arrange your investments to be as tax-efficient as possible. 

Let’s start with the types of investment income earned within your portfolio. Each is subject to a different tax treatment. Here are the four most common types:

• Interest income: Payments received for lending funds to a borrower are taxable at your marginal rate — the tax rate that applies to the top tier of your employment income under Canada’s graduated-tax system. This includes interest earned from bank accounts, guaranteed investment certificates (GICs), bonds and fixed income mutual funds, exchange-traded funds and all other interest-producing investments.
• Capital gains: Profits from the sale of property or investments are taxable only when realized — that is, when you sell or transfer the property. Only 50% of the increase over what you originally paid is taxable at your marginal rate.

• Dividends from Canadian corporations: Payments to shareholders, usually as a share of the company profits. A dividend can be designated as non-eligible or eligible. Dividends qualify for the dividend tax credit, which reduces your total tax due. Eligible dividends qualify for an enhanced tax credit. The precise effect will vary according to your overall income and province of residence.
• Dividends from foreign corporations: Dividend distributions from non-Canadian corporations are subject to a different tax treatment. They are fully taxable at your marginal rate and do not qualify for a dividend tax credit. In addition, in most cases there will also be withholding taxes paid to the foreign country, the amount depending on the country, the type of investment product and type of account holding the shares. A foreign tax credit may be available and could reduce the tax payable in Canada on the dividend. Other particularities may apply and it is best to consult with a tax professional to fully understand tax implications of any foreign dividends you receive.
• Return of capital: When an investment pays a regular distribution, but the interest, dividends and realized capital gains are less than the fixed distribution amount, the difference is considered return of capital to its investors. This is not considered income and is not taxed in the year it’s received. Instead, it is subtracted from the price you originally paid for the fund, resulting in a larger capital gain when you eventually sell or transfer it. 

Maximizing RRSPs

To have more money in retirement and pay less tax now, you may want to contribute as much as you can to your Registered Retirement Savings Plan (RRSP). Here are some ways to achieve that:

• Once you have used up your annual contribution room, fill any deduction room carried forward from previous years when you didn’t make your maximum contribution.
• Consider automating your contributions by setting up a pre-authorized contribution. You contribute on a regular basis over the year – weekly, bi-weekly, monthly or quarterly – instead of a lump sum.
• Tax refunds and company bonuses can also help you fill unused contribution room.
• Consider starting or adding to a spousal plan. A spousal plan is useful if your spouse has little set aside for retirement and does not expect a significant pension or other retirement income. Contributing to a spousal RRSP while you’re still working can help equalize your retirement savings as a couple. This will make your retirement incomes more equal, which can lower your overall household income tax in retirement.

Remember the Tax-Free Savings Account (TFSA)

You can also save in a TFSA. While contributions are not tax-deductible, your investments will grow tax-sheltered and will not be taxed on withdrawal. Plus, unlike an RRSP, you do not have to collapse your TFSA when you reach a certain age and contribution room does not depend on your income. 

Minimize tax on non-registered investments

By coordinating your registered and non-registered portfolios, you may be able to reduce your overall tax liability.

Maintain tax deferral with a Registered Retirement Income Fund (RRIF)

When you collapse your RRSP, you can continue to benefit from tax-deferred growth by rolling the assets into a RRIF. While you must withdraw a certain amount from the RRIF each year, amounts remaining in the plan are tax-deferred. 

You may need to adjust your RRSP portfolio when this roll-over occurs, shifting from an emphasis on growth and capital preservation to a strategy aimed at growth and income. 

Holding investments that generate fully taxable interest income in your RRSP or RRIF allows them to grow in a tax-sheltered environment. Meanwhile, holding equities and equity mutual funds in your non-registered accounts allows you to benefit fully from the Canadian dividend tax credit and the preferential tax treatment for capital gains. 

The tax implications of investment income should never be the main factor in an investment decision. Your portfolio should be structured for your time horizon, liquidity needs and risk tolerance. But within those guidelines, paying attention to tax implications can help you reduce your tax bill, so there’s more left for you to invest and enjoy in retirement.

The information provided in this article is for general purposes only and does not constitute personal financial advice. Please consult with your own professional advisor to discuss your specific financial and tax needs.