Higher interest rates are rewarding savers. With a few simple moves you could be holding the same investments and pay less in taxes.
Article by: https://epsgheavyweights.com
Many Canadians savers can’t remember the last time interest rates were this high. The Bank of Canada overnight rate is 5% making it easy to find fixed income products paying north of 4.5%… but watch out for taxes.
When it comes to saving for the future, it’s not just about how much you put away, but also how much you keep after taxes. By making a few simple changes to your savings strategy, you can potentially pay less in taxes and keep more of your hard-earned money.
Interest earned in non-register accounts is taxed at your marginal rate which can be more than 30%. For years this has not been a concern with interest rates hovering around 1% or less. In fact it made sense to keep Canadian dividend paying stocks in your registered accounts and your cash outside… still does in some situations. However, with rising interest rates, savers holding cash should consider some simple moves to maximize returns and pay less in taxes.
#1 Don’t leave money on the table
First and foremost, make sure you are taking full advantage of these higher interest rates. Don’t leave thousands of dollars in chequing accounts paying 0% without a good reason. It’s fine if you know you’re going to need the money in the very near future. Another good reason to keep a few thousand bucks in an account may be to avoid bank fees. Otherwise everything else should be in high interest savings.
#2 Move investments and pay less in taxes
If you are a saver you probably have a discount brokerage account. This gives you the most flexibility to hold the right investment in the most tax efficient account.
Recently I have been moving dividend tax credit eligible investments from my registered to non-registered accounts. Since the stocks could not be transferred between accounts, they were sold from one account and immediately bought back in the other. Then I bought investments in my registered account that would otherwise be taxed at my full marginal rate. These include high interest savings, REITs, and US dividend paying stocks*.
Below I have provided an example comparing interest vs. eligible dividends on two $25,000 investments.
#3 Consider alternative eligible investments
Finally, consider alternative long term dividend tax credit eligible investments. Recently I purchased my first perpetual preferred share. The price of these shares typically start out at $25 and are inversely proportional to interest rates. Meaning when rates go up the share price goes down and vice versa. This however can be a good thing, because the dividends are fixed and as prices come down the yields go up . You can now find many perpetual preferred shares priced under $20 with an eligible dividend in excess of 6%. For long-term investors this locks in a 6% annual yield with a potential 25% capital gain when rates come down or they are redeemed by the issuer. It will be interesting to see how this investment works out for me.
This article won’t go into any more details on Canadian preferred shares but if you are interested in learning more here is a link to an excellent resource. https://canadianpreferredshares.ca/
Link Disclaimer: Link provided for convenience for information purposes. Contact external site for answers to questions regarding their content.
Example of Investor Looking to Pay Less in Taxes
Moh lives in Ontario making $100,000 a year with a marginal tax bracket is 37.16% (26% Federal + 11.16% Provincial). He currently holds $25,000 of Fortis (FTS.TO) in his RRSP. Since his broker is TD he also holds $25,000 of their High Interest Savings fund (TDB8150) in his non-registered account. At the time of writing Fortis’ dividend was yielding 4% and TDB8150 was paying 4.55% interest.
The rise in interest rates prompted Moh to compare his options. Since he considers both investments to be long-term savings he wants to see if he can pay less in taxes.
Current tax calculation:
| Holdings | RRSP (Not Taxable) | Non-Registered (Taxable) |
|---|---|---|
| Fortis (FTS) $25,000 with 4% dividend | Eligible Dividend = $1,000 Tax = $0 | |
| TD Savings (TDB8150) $25,000 with 4.55% interest | Interest = $1,137.50 Tax Payable = $422.01 at 37.16% |
After tax Moh keeps $1,715.49 (i.e. $1,000 + $1,137.50 – $422.01)
Flip investments between accounts:
| Holdings | RRSP (Not Taxable) | Non-Registered (Taxable) |
|---|---|---|
| Fortis (FTS) $25,000 with 4% dividend | Eligible Dividend = $1,000 Tax Payable = $167.53 | |
| TD Savings (TDB8150) $25,000 with 4.55% interest | Interest = $1,137.50 Tax = $0 |
After tax Moh keeps $1969.97 (i.e. $1,137.50 + $1,000 – $167.53)
Moh will pay less in taxes if he sells Fortis from his RRSP and buys it back in his non-registered account to take advantage of the dividend tax credit. He then uses the cash in his RRSP to immediately purchase a high interest savings product like TDB8150 so it can grow tax free. It’s also important to enable dividend reinvestment or DRIP on these investments to harness the power of compounding.
Detailed dividend tax credit calculation:
If you’re interested in the math behind the dividend tax credit I have included the detailed calculation below. If not just skip this section.
Disclaimer… the dividend tax credit calculation is funny. Eligible dividends are initially grossed up on your T5 slip before the credit is calculated. In the end it works out much better for the investor as shown in the example above. If you want to learn more about the dividend tax credit calculation here’s a link to a good article.
https://www.planeasy.ca/how-are-dividends-taxed-help-lower-taxes-in-retirement/
Link Disclaimer: Link provided for convenience for information purposes. Contact external site for answers to questions regarding their content.
Eligible Dividend = $1,000
Gross Up= $1,380 ($1,000 at 38%)
Tax on Gross = $512.81 ($1,380 x 37.16% Marginal Rate)
Federal Credit= $207.27 ($1,380 x 15.0198%)
Provincial Credit= $138.00 ($1,380 x 10%)
Tax Payable= $167.53 ($512.81 – $207.27 – $138.00)
Holding Fortis in his non-registered account may trigger capital gains in the future when Moh sells his shares. While true these gains are taxed at 50% and may not occur until he is retired with a much lower income. Conversely if sold at a lower price in his RRSP he will not be able to claim a capital loss.
Conclusion
Rising rates will benefit savers and those looking to shelter cash. Like Moh, you need to review your investment strategy. What worked in a low interest rate environment may no longer be tax efficiency. With some simple changes savers can pay less in taxes without adding risk. Everyone’s situation is different but it is important to look for opportunities to keep more of your hard earned money.
Remember, if you are not comfortable making these changes it’s important to consult with a tax professional or financial advisor. They can provide personalized guidance based on your individual circumstances and help you optimize your tax savings. By taking advantage of these simple changes, you can potentially pay less in taxes and grow your savings.
* US dividends are taxable in TFSA but not in other registered accounts like RRSP.
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