The Impact Of Tax On Investment Income

When looking at investments opportunities, the number 1 rule is to always think after tax. Investment incomes are taxed just like employment income but some investments are taxed differently and at different rates. Take two different investments; one pays 10% and the other pays 12%. On the surface, the 12% looks better. However, if the 10% was dividends from companies and the 12% was interest from bonds then the picture completely changes. Divides are taxed at a much lower rate than interest. This is why when you’re deciding what to invest in, you must look at the tax impact.

The impact taxes have on an investment is huge. The best way to show this difference is by comparing a tax sheltered investment vs. an unsheltered investment. Let’s assume you have $10,000 to invest for your retirement. If you were to put this $10,000 inside your RRSP (401K or IRA in the US), any income the investment makes is completely tax-free until you take it out. If you were to leave the funds inside for 30 years and average 10% return, you would have $174,494.02 at the end of 30 years to help fund your retirement.

If you were to invest this $10,000 outside of a RRSP, the income it makes will be subject to tax at your marginal rate. If you’re at the 40% tax bracket, it would mean $400 in taxes in the first year ($10,000 at 10% return = $1,000 @ 40% tax = $400 in taxes). That leaves only $600 to put back into investments, where as the RRSP will allow you to put the full $1000 back. The impact over 30 years is huge. Instead of having over $174K for retirement, you’ll have just $57,434.91.

Even if you were to withdraw the entire $174K and pay the maximum 48.6% withholding tax, you’ll still come out ahead of the game because you shelter the income for the past 30 years. However, there are ways to get the money out with little or no tax impact.

The first way is to transfer the money into a Registered Retirement Income Fund (RRIF) and have it pay you the yearly tax free amount. In Canada you’re allow to make $8,000 a year tax-free (the amount increases every year). If you set up the RRIF to give you $8,000 per year (adjusted to the yearly increases), you can effectively take the money out over time without paying any taxes – assuming you can live on $8,000 a year, which is not very likely. However, if you have funds from other sources, like a reverse mortgage or money borrowed against a life insurance policy (these are not subject to tax) then this retirement trick can work.

The other way to minimize the tax is be retire outside Canada. Unlike the US, Canada taxes its citizens based on residency. If you leave or retire outside of Canada, you are no longer subjected to Canadian tax, even though you’re still a Canadian citizen. If you wait until you become a non-resident (six month plus a day outside of Canada), you can withdraw all the funds inside your RRSP by paying a 25% withholding tax. This a lot better than paying 48.6%.

Another way to minimize the tax on the money taken from your RRSP is to take a series of smaller payments instead of collapsing it all at once. As long as you withdraw no more than $5,000 at a time, the withholding tax is only 10%. Therefore, it is possible for a non-resident to exhaust their RRSP over time at a cost of only 10%. This wouldn’t work as well if you stayed in Canada because the amount you withdraw will be added to your total income at tax time and Revenue Canada will then get their share. However, a non-resident no longer has to fill or pay Canadian income tax.


11 thoughts on “The Impact Of Tax On Investment Income”

  1. Matt $tidham says:

    “Another way to minimize the tax on the money taken from your RRSP is to take a series of smaller payments instead of collapsing it all at once. As long as you withdraw no more than $5,000 at a time, the withholding tax is only 10%.”

    How often can you take this 5000 out?

  2. John Chow says:

    There are no set limits but you shouldn’t be doing it every day. Once or twice a month should be no problem, unless you really need more than $10K a month to live on.

    Remember, this only works if you’re become a non-resident. If you don’t, Revenue Canada will get the remaining taxes owed on the withdrawals at tax time.

  3. Ronnie says:

    This seems more elaborate than most people are are willing to do. Even me… laziness is the easy way.

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  4. Gary says:

    Interesting post John.

    As a business owner do you feel it is better to invest in retirement now or grow your business?

  5. Mayo says:

    I have opened Belize Ltd. company, and i won’t have to pay not even a 1% tax on that revenue, you can also for almost no cost open a Cyprus, Austrian or Isle of Man offshore account, only i don’t think the CC transactions are cheap, you should transfer a bundle say over 2K$-10K$ to your resident account, or spend several thousands because transfer rate is between 5 and 10€, but that doesn’t matter because you will use it as a TAX shelter, and transfer monthly allowance to your resident country.
    You can have a registered “consulting job” in your country and pay your self what ever you wish to(based on your income 😉 ).
    For me, i will pay only for necessary things, keep the taxes low and shelter rest of it, and when you earn 100K$, why give a government 40K$?? For that money you can X10 buy a beautiful house in Bermuda, Costa Rica, Belize or Switzerland 🙂

  6. Mayo says:

    Oh and imagine how many $$ you can give to charity! 😉

  7. John Chow says:

    Mayo – For most people, setting up an offshore account doesn’t make financial sense, because most people have employment income. The money you’re sending offshore has already been taxed. And if you bring the money back into the country to pay to you as consulting fee, then it’s consider income and you’ll get tax on it again.

    Having said that, offshoring is a great way shelter income. I may do a blog post on it in the future.

    Ronnie – When you start dealing in the 100’s of thousands (or millions), it won’t matter how elaborate it is. Even making some small changes now can have a huge effect down the road.

    Gary – Depends on what stage your business is in. If you’re a startup then all efforts must go to the business. If your business is on solid grounds, then you can look at way to fund retirement.

  8. rob klein says:

    Hey Bro,

    hehe, check out the distributions on wrap portfolios from quotential…..its all un realized capital gains, not realized gains every single year.

    cheers
    rob klein

  9. FrugalTrader says:

    “If you were to invest this $10,000 outside of a RRSP, the income it makes will be subject to tax at your marginal rate. If you’re at the 40% tax bracket, it would mean $400 in taxes in the first year ($10,000 at 10% return = $1,000 @ 40% tax = $400 in taxes). That leaves only $600 to put back into investments, where as the RRSP will allow you to put the full $1000 back. The impact over 30 years is huge. Instead of having over $174K for retirement, you’ll have just $57,434.91.”

    This is not accurate John. If you invest $10k outside of an RRSP, you ONLY pay taxes when you SELL your stock at a profit (or collect dividends). Even then, only 50% of your profit is taxable (capital gains tax, dividend income is different). So, if you are in a 40% tax braket, make $10k PROFIT on a stock when you sold it, you would pay taxes on $5k at your marginal tax rate. If you are in the 40% marginal tax rate, you would only pay $2k taxes, which works out to be 20% NOT 40%. Investing OUTSIDE an RRSP is a viable solution for some. Please see taxtips.ca for more accurate tax information

    Now if you make $10k in INTEREST income for the year (like in a bond, GIC, or high rate savings account), THEN $10K would be added as income in your marginal tax rate. Thus, at a 40% tax rate, you would pay $4k in tax.

    So INTEREST income should be kept inside (due to high taxes), but capital gains and dividend income can be kept outside due to tax efficiency.

    FrugalTrader
    http://www.MillionDollarJourney.com

  10. John Chow says:

    FrugalTrader – You are correct. I should made clear in my example that I was using interest only.

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