Taxes Reduce Your Investable Income
Many investors put their funds in non-registered accounts in order to avoid the high tax rates associated with dividend and interest income. This includes mutual funds, stocks, options, Exchange Traded Funds (ETFs) and bonds, as well as GICs. They pay lower tax rates. However, they may also cause several other tax issues for the investor.
Mutual funds are usually a good investment product because they offer diversification and lower cost than investing in the individual stocks and bonds themselves. However, when you sell mutual funds, not all of your capital gain is taxed at the lower tax rate. In fact, only 60% of the capital gain is taxed at your marginal income tax rate, or the rate you would pay if you reported all of your income. The other 40% is reported as a taxable capital gain in your income taxes and is subject to a much higher tax rate than the first 60%. Although this is only an approximate figure, it is a good rule of thumb to help you understand the tax implications of investing in mutual funds.
Taxes Reduce Your Real Returns
When you make a deposit to your investment account, you get an immediate reduction in your taxes. Within a traditional IRA or 401K, you’ll be able to deduct your deposit from your income taxes, and you don’t have to pay it back through taxes until you withdraw money from the account. This makes investing through a traditional IRA or 401K a tax-advantaged way of growing your retirement nest egg.
But it’s important to remember that although the money you deposit into an IRA or 401K reduces your taxes, it doesn’t go toward increasing your net worth. In fact, it actually lowers your net worth. In other words, the taxes you’re saving for retirement are more than offset by the taxes you’ll have to pay when you retire and start pulling money out of your retirement accounts.
What about Tax-Efficient Investments?
Most people realize they need to pay taxes on a variety of different investments, including the interest you earn on savings accounts. Because tax shelters can reduce the overall amount of tax you’ll pay, some people choose to hold a portion of their investment portfolio in tax shelter investments like RRSPs, RRIFs, and TFSAs.
Each of these accounts has a variety of different rules and regulations that dictate how you can invest your money. For example, RRSPs have strict contribution limits, and many RRSP investments come with added tax advantages that are unique to that particular investment. 2
However, it’s not really worth it to put a large portion of your portfolio into these tax shelters. Instead, it’s better to put your money into investments that aren’t as tax friendly but over time have the potential to produce higher returns and a higher net worth.
One of the most common investments people use to build a portfolio are stocks, which are often taxed at a higher rate than bonds. But over time and over long periods of time, stocks usually perform better than bonds and produce bigger net worth.
Whether you’re holding one investment or an entire portfolio of investments, understanding how taxes can affect your decisions is an important part of maintaining and building wealth.