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Conventional wisdom says we should earn highly taxed investment income in tax-deferred accounts and more tax-efficient income in taxable accounts. Practically speaking, this means investors should hold interest-bearing investments in registered accounts and investments that generate eligible dividends and capital gains in non-registered accounts.

But do ultra-low interest rates challenge this conventional wisdom?

To answer that, we need to shift our focus away from the tax rate in percentage terms to the tax cost in dollar terms. We know that interest is taxed at a higher rate than both capital gains and eligible dividends. However, expected interest rates, dividend yields and capital appreciation can vary. These variations can offset the tax rate differences and therefore the taxes payable.

Read: Don’t panic about corporate-class funds

For example, an investment that generates 1% interest income will have the same tax cost (in dollar terms) as an investment that has a realized capital gain of 2%. This is due to the fact that capital gains are taxed at half the rate of interest income. In this case, an investor should be indifferent between earning 1% interest in a taxable account and realizing a 2% capital gain, as both would generate the same level of tax in dollar terms. The rate of eligible dividends needed to generate the same tax cost as interest income varies by tax bracket and province of residence.

Determining the capital gain and eligible dividend income that would generate the same tax cost as an interest-bearing investment can be referred to as the investment’s breakeven rate (for an example, click here). Knowing the investor’s risk profile, these breakeven rates, along with current interest rates, can help us determine where to hold various investments (RRSP, TFSA or non-registered accounts).

If we expect a portfolio to generate a higher capital gain or dividend yield than their respective breakeven rates, then holding investments generating this income may be better suited for an RRSP or TFSA as opposed to a non-registered account. The reason is that the amount of tax paid on this income will exceed the tax that would have otherwise been paid on the interest income. (It’s worth noting that investors should consider their TFSAs and RRSPs to be primary savings vehicles; considering asset location is meant for investors who have hit their contribution limits and continue to save in non-registered accounts.)

Let’s take a closer look at this concept. We’ll compare the tax cost of interest, capital gains and eligible dividends when the breakeven rates for capital gains and eligible dividends are exceeded. Then, we’ll explore the tax cost when an investor is unable to meet the breakeven rates of return.

Consider Amy, an Ontario investor in a 46% tax bracket. Assumptions:

  • She’ll continue to be in that bracket for the next 10 years.
  • She has $50,000 to invest.
  • Current interest-bearing investments generate 1%; therefore, our breakeven rate is 2% for capital gains and 1.59% for eligible dividends. Investments that would earn interest, eligible dividends or capital gains at these rates would all generate a tax liability of $230 if earned in a taxable account in the current year.

What if Amy is able to generate a 5% realized capital gain each year or 3% per year in eligible dividends? Would the tax cost on the capital gains or eligible dividends be greater than the interest income? If so, Amy may prefer to invest inside her RRSP or TFSA as opposed to investing tax-efficient income outside those plans.

Annual tax cost for investments earning 1% interest, 5% capital gains and 3% eligible dividends

Chart A: Annual tax cost for investments earning 1% interest, 5% capital gains and 3% eligible dividends.

You will notice that interest income generates the lowest tax cost, followed by eligible dividends. Capital gains generate the highest tax cost in dollar terms despite being the most tax-efficient form of income. In fact, the cumulative tax cost for interest over the 10-year period is $2,357, compared to $4,784 for eligible dividends and $6,856 for capital gains.

In other words, earning capital gains in a registered account would provide Amy with the greatest overall tax savings, followed by eligible dividends. And, despite having the highest tax rate, Amy pays less income tax on interest income over the 10-year period.

Read: 5 strategies for tax-efficient investing

When interest rates are high

Let’s look at an alternative scenario where returns from interest-bearing investments exceed the breakeven rates. Let’s assume interest rates are at 10%. In this scenario, breakeven rates for capital gains and eligible dividends would be 20% and 15.89%, respectively. While Amy can earn 10% interest, she is only able to generate 8% capital gains and 5% in eligible dividends. Which source of investment income has the highest tax cost in this scenario?

Annual tax cost for investments earning 10% interest, 8% capital gains and 5% eligible dividends

Chart B: Annual tax cost for investments earning 10% interest, 8% capital gains and 5% eligible dividends.

As you can see, when the rate of return for capital gains and dividends is less than the breakeven point, the tax cost in dollar terms is less than their interest income counterpart. In a high-interest-rate environment, it’s better for investors to shelter interest income from tax in a registered plan. As you can see, the tax cost differences are significant. Eligible dividends have the lowest cumulative cost of $8,512. Capital gains were the next lowest at $12,218 and interest income had the highest cost of $29,475.

Conclusion

First and foremost, investors should maximize their TFSAs and RRSPs to benefit from tax-free and tax deferred investment growth. For investors who have maxed out their RRSPs and TFSAs and still require more savings, further decisions need to be made.

First, evaluate current interest rates and calculate the breakeven rates for capital gains and eligible dividends.

Next, assess the probability of meeting or exceeding these breakeven rates based on risk profile and time horizon.

Finally, if the probabilities for exceeding the breakeven rates are high, use the client’s RRSP and/or TFSA to earn capital gains and eligible dividend income, and non-registered accounts for interest income.

In any interest rate environment, when you are able to match or exceed the breakeven rates, earn capital gains and dividend income in registered accounts. Doing so will help reduce a portfolio’s tax cost.

Let’s look at an example using an Ontario investor with a 44% marginal tax rate (MTR). If he had $10,000 to invest and interest rates are currently 1%, what are his breakeven rates?

1% interest income $100
Tax rate 44%
Tax cost $44
2% capital gains $200
Capital gains inclusion ($100)
Taxable capital gain $100
Tax rate 44%
Tax cost $44
1.68% eligible dividends $168
138% gross up value $232
Tax rate 44%
Tax before credit $102
Less: Dividend tax credit $58
Tax cost $44

Curtis Davis, FMA, CIM, RRC, CFP, is senior consultant, Tax, Retirement & Estate Planning Services, Retail Markets at Manulife.
Originally published on Advisor.ca
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