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(Thursday, January 14, 2010)
With RRSP season coming, you will soon be bombarded with ads reminding you to make your RRSP contribution before the deadline. Leaving the decision on how much to invest, and where, until the last minute can result in some expensive mistakes. Before you lock yourself into making a routine RRSP contribution, take some time to look at your investment options. As part of you overall plan, you should consider the income tax effects of your investment. Some things to keep in mind are:
Your investment decisions should be different depending on your marginal tax rate. If you are in a high tax bracket, then tax deductible RRSP contributions are attractive because they yield an immediate tax refund. If you are in a low tax bracket, you don’t benefit as much, or even at all, from the RRSP deduction.
Similarly, investments such as Flow Through Shares or Limited Partnerships, which can give you a tax deductible expense, result in a bigger refund for those in a high income tax bracket. However, these types of investments are often riskier than bonds or mutual funds. This can sometimes be a good thing, because if the Flow Through Shares or Limited Partnership units retain or gain in value, they will yield a capital gain on sale, which is taxed at half the rate of other income.
Other investments, such as Labour Sponsored Investment Funds and Venture Capital Corporations result in tax credits, which are the same amount no matter what your tax bracket. There are a number of investment vehicles available based on a variety of tax credits from the Federal and Provincial Governments. The point to keep in mind with such investment vehicles, is that they may be poor investments in spite of the tax credits they yield, and end up worth little or nothing. They also typically require that the investor cannot sell them for some years.
Dividend yielding investments result in a dividend tax credit based on the absolute amount of the dividend. As a result, those in a lower income tax bracket pay less, or no, taxes on dividends from Canadian sources. This makes them an attractive investments for lower income investors: however, seniors need to be aware of a problem. Due to the way dividends are reported on the income tax return, dividend income is shown at 145% or 125% of the actual dividend, and then the taxes due are calculated. The dividend tax credit is then deducted from the taxes owing. As a result, net and taxable income on the tax return is inflated and may result in reduction or “clawback” of social assistance benefits such as OAS and Guaranteed Income Supplement.
The rules don’t allow registered plans such as RRSPs or Tax Free Savings Accounts to hold real estate, so you cannot hold a rental property inside the plan. Instead, you could invest in Real Estate Investment Trusts, or shares of corporations that own rental property inside your RRSP or TFSA. Or, you could own rental property personally, which has some advantages for tax purposes.
Although net rental income is fully taxed, like interest income, and therefore isn’t as attractive as dividend income or investments yielding tax credits, selling a rental property yields a capital gain only half of which is taxable. In fact, if the rental property is also your principal residence, any gain on the sale may be tax free if the rules are followed.
If you aren’t sure about what, if any, investment to make, talk to your accountant or investment adviser well before the RRSP deadline.
