If your long-term savings are all in RRSPs and TFSAs, consider yourself lucky. Using tax-sheltered accounts is easy compared with the plight of investors who are saving in non-registered accounts. From deciding on the right asset location, to harvesting losses, to calculating the adjusted cost base of your holdings, taxable investments are always a challenge. But André Fok Kam’s new book, Tax-efficient Investing for Canadians, will make the job easier.
There are countless books on taxes, but this is the first one I’ve seen that focuses specifically on investments, and it’s loaded with excellent advice. Here are three tips to give you a taste:
Be careful when reinvesting distributions. In the chapter covering the tax implications of mutual funds and ETFs, Fok Kam explains why distributions add no value: “Instead, they merely transfer value from the fund to its unitholders. Investors are enriched when the fund earns a return, not when it transfers value.”
Cash distributions can help pay living expenses if you’re drawing down your portfolio. But investors in the accumulation phase often reinvest all distributions, which is a potential problem at tax time, Fok Kam says. You might not even be aware of what you will owe in taxes, and you may not have enough cash available when you file your return. “You can avoid these surprises by examining your fund statements very carefully when you receive them.” I’d add you might simply avoid DRIPs in taxable accounts, and you should think carefully before choosing funds with high distributions if you don’t need current income.
Understand the superficial loss rule. The book also includes an excellent chapter on capital gains. “A fundamental principle of tax-efficient investing is to defer the payment of tax on capital gains whenever possible,” Fok Kam writes. “It is always better to pay tax later rather than sooner. In the interval, the money can be reinvested and generate additional returns.”
In his discussion of tax-loss harvesting, Fok Kam explains how you can run afoul of the superficial loss rule by purchasing a security before selling shares to crystallize a loss. Most people understand that if you sell a security to harvest a capital loss you must wait 30 days to repurchase it or the loss will be denied. But Fok Kam reminds us of another pitfall. He uses an example of an investor who owns 500 shares of a company that has recently fallen in value. The investor still likes the company’s prospects, so he increases his position to 1,000 shares and then sells 500 to capture a loss. Nice try, but “the [superficial loss] rule applies whenever the same property is bought within 30 calendar days before or after the sale of the original property.”
You can turn dividends into capital gains. You might think you have no control over whether to accept your equity returns in the form of capital gains or dividends. But the book explains one situation where you actually get to choose.
Say you hold 500 shares of a Canadian dividend-paying ETF and the fund announces a payout of $0.50 per share with a record date of Thursday, July 5. The ex-dividend date is two business days before that, or Tuesday, July 3: if you sell the ETF prior to this date you will not receive the upcoming dividend. You should also expect the ETF’s price to drop by the amount of the distribution on the ex-dividend date.
Let’s assume your 500 shares have increased in value by $2,000 as of Monday, July 2. If you sell them on that day (before the ex-dividend date), you would realize a capital gain of $2,000 and you would not receive the announced dividend. However, if you sold the shares the following day (July 3), the share price will have fallen by $0.50, so your realized capital gain would be only $1,750, but you would also receive the $250 dividend. The total proceeds are the same in both cases. But if you’re in a low tax bracket (where Canadian dividends are taxed more favourably than capital gains), you should choose the latter strategy. If you’re in a high tax bracket, you should do the former and take the whole thing as a capital gain.
Tax-efficient Investing for Canadians is published by the IFSE Institute and can be purchased directly from their website (click “Shop as a Guest”). The full cost, including UPS shipping and a processing fee is about $29.