Tax Efficient Investing
What you invest in has a significant impact on the rate of growth of any investment. Likewise, investments that feature tax-exempt or tax-deferred income will grow faster. Tax efficiency also provides a hedge against inflation, particularly if it increases rates of return that can exceed inflation rates.
Here is our recommended order of investing, starting with the most tax-efficient.
Priority 1 Pre-tax capital:
Registered Retirement Savings Plan (RRSP), Registered Pension Plan (RPP).
Whole dollars are invested because the investment results in a tax deduction.
Taxation on compounding earnings is deferred but both principal and earnings are taxed on withdrawal.
Priority 2 Post-tax, government-enhanced:
Registered Education Savings Plan (RESP), Registered Disability Savings Plan (RDSP).
These investments are made with tax-paid dollars (no deduction available when contributing).
Earnings grow on a tax-deferred basis in these plans, but the priority is increased because the government enhances the deposit with matching grants and bonds.
Priority 3 Post-tax, tax-exempt
Tax Free Savings Account (TFSA), insurance, principal residence equity.
Earnings grow without taxation, and are not taxed on disposition, but these investments are made with tax-paid dollars.
Using tax savings from an RRSP is a good way for you to fund this category.
Priority 4 Post-tax, tax-preferred
Tax-paid capital is invested in non-registered accounts and may generate tax-preferred income:
Dividends and capital gains income is taxed annually (interest, dividends, rents, royalties)
Increases in value as assets are subject to tax on disposition, resulting in a capital gain or loss.
ACTION PLAN: Use capital as a tool
The following checklist can help to build principles for investing and prioritize investment choices:
Qualifying income? If you have available RRSP room, maximize RRSP contributions first to create tax savings, tax-deferred income and new capital.
Leveraged tax refund? Leverage any additional tax refund created to top up unused carry-forward room in your RRSP/RPP.
Government incentives? Take advantage of Canada Education Savings Grants and Bonds or Canada Disability Savings Grants and Bonds to save for education of children or grandchildren or pensions for the disabled.
Savings or parking money? Open a Tax-free Savings Account (TFSA) if you’re at least age 18.
TFSA or RRSP: Which first? Read this article to find out.