Topic: How To Invest

Tax shelters in Canada: 3 choices you need to know about

tax shelters in canada

Tax shelters in Canada that can help you save money when you use them correctly

Tax shelters in Canada aim to reduce or eliminate your tax liability.

Tax shelters are legal investment vehicles that let investors pay less tax. Some are risky and should be avoided, like flow-through limited partnerships, but others, like RRSPs and TFSAs, are great ways for Canadian investors to cut their tax bills. In the U.S., IRAs and 401ks are examples of retirement tax shelters. In Canada, tax shelters are closely monitored and regulated.


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Tax shelters in Canada: Tax-Free Savings Account (TFSA)

The federal government first made the tax free savings account (TFSA) available to Canadian investors in January 2009. These accounts let you earn investment income—including interest, dividends and capital gains—tax free. You could contribute $5,000 in 2009 to start your tax free savings account. The only qualification was that account holders be 18 years or older.

On January 1, 2013 the annual contribution limit increased to $5,500. It has remained at $5,500 since then, with the exception of 2015, when it rose to $10,000. That means that if you haven’t contributed yet (and were 18 years or older in 2009) you can now contribute up to $52,000 in 2017.

Tax-free savings accounts let you earn investment income—including interest, dividends and capital gains—tax free. But unlike a registered retirement savings plan (RRSP), contributions to TFSAs are not tax deductible. However, the withdrawals you make from a TFSA are not taxed.

The only restriction is that you can’t put the money you took out back in the same year (unless you have sufficient contribution room for it to be considered an additional contribution).

Tax shelters in Canada: Registered Retirement Savings Plans (RRSPs)

You can put money in a Canadian RRSP (Registered Retirement Savings Plan) tax shelter each year (up to a limit based on your income) and deduct it from your taxable income. You only pay income tax on your investment, and the income it earns, when you make withdrawals from your RRSP.

A properly structured investment portfolio can let you take advantage of the low tax rate on capital gains and dividend income outside of your RRSP, while it shelters your higher-taxed interest income in your RRSP.

Generally speaking, it’s best to hold interest-bearing investments inside an RRSP. That’s because, of the three forms of income (interest, dividends and capital gains), interest is the highest taxed. Dividend-paying investments, and those expected to yield capital gains, are best held outside—unless you only hold dividend-paying stocks, and then they are okay to hold in your RRSP. Some investors only invest RRSP funds in interest-paying securities, because they hate to see tax advantages go to waste. However, this makes less sense when interest rates are low.

Stocks come with two key tax advantages. The dividend tax credit applies to dividends from Canadian companies, so they are worth around one-third more, after tax, than the same amount of income from interest. This advantage goes to waste in an RRSP.

If you hold dividend-paying stocks in your RRSP tax shelter, you defer taxes, but lose the dividend tax credit. When you withdraw money from your RRSP, you’ll pay taxes on those dividends at the same rate as regular income, regardless of how you earned the money. So it’s best to hold dividend-paying stocks outside your RRSP—again, unless you only hold dividend-paying stocks, and then they are okay to hold in your RRSP.

For example, an investor in the 50% tax bracket would pay 50% tax on interest income. Dividend income, after factoring in the dividend tax credit, would be taxed at only around 25%. Capital gains would be taxed at just 29%.

So, if you hold dividend-paying stocks in your RRSP tax shelters, you defer taxes, but lose the dividend tax credit. When you withdraw money from your RRSP, you’ll pay taxes at the same rate as regular income, regardless of how you earned the money. So it’s best to hold dividend-paying stocks outside your RRSP.

Tax shelters in Canada: Registered Retirement Income Funds (RRIFs)

A RRIF is a Registered Retirement Income Fund, a tax-deferred retirement plan for your Registered Retirement Saving Plan (RRSP). RRIFs are used by those who don’t plan to cash out their RRSP as a lump sum when they retire, and prefer to extend their investment and take smaller withdrawals by converting to a RRIF. Registered Retirement Income Funds offer more flexibility and tax savings than annuities or a lump-sum withdrawal.

Converting to a RRIF is the best retirement investing option for most investors. That’s because RRIFs offer more flexibility and tax savings than annuities or a lump-sum withdrawal.

Like an RRSP, a RRIF can hold a range of investments. You don’t need to sell your RRSP holdings when you convert—you just transfer them to your RRIF.

When you hold a RRIF, you must withdraw a minimum each year and report that amount for tax purposes. (You may withdraw amounts above the minimum at any time.) Revenue Canada sets your minimum withdrawal for each year according to a schedule that starts at 5.28% of the RRIF’s year-end value at age 71, reaches 6.82% at age 80, and levels off at 20% at age 95.

Canadians don’t seem as interested in RRSP as they once were. Have RRSPs lost your interest?

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