US Non-Resident Withholding Taxes and Asset Location

Dividends and interest from US securities are subject to the US Non-Resident Withholding Tax (currently 15%). However, the US-Canada Tax Treaty grants an exemption for certain registered accounts like RRSPs. So if you hold those securities in an RRSP (or certain other accounts), you will not be subject to the withholding tax. (Your brokerage usually handles getting this information to your ETF company so that they do not withhold the tax.)

Now that TFSAs are available, many people are treating them as an extension of the RRSP. But you should be aware that TFSAs are not exempt from the Non-Resident Withholding Tax under the US-Canada Tax Treaty.

So, considering only that you want to minimize the US Non-Resident Withholding Tax, the RRSP is the preferred location for applicable holdings. No withholding tax is applied. The next-best place is in a taxable account, because you can claim a foreign tax credit on the withholding tax paid. The worst place is the TFSA, because it is not exempt from withholding tax and on top of that, since it is not a taxable account, you cannot even claim the foreign tax credit.

Get All The Benefits That You Qualify For

When we enter the various stages of our lives, we are often so busy adjusting to the changes that we don't look into benefits that we should be getting. Since you must apply for many of the benefits available, a lot of us miss out on those benefits for some time while we sort out our lives. Some of the significant events that can qualify you for benefits that you were not previously collecting are:

• Marriage
• The birth of a child
• Change in income or employment status
  
• Health changes and deaths in the family
  
• Retirement

For instance, with the birth of a child, here are some of the things you can do:

• Set up an RESP for the child's education
• Collect the Universal Child Care Benefit
• Collect the Canada Child Tax Benefit

It is hard to keep track of all the programs that are available, both from the federal government as well as from your province, but the government has set up a handy web site to help you find all the benefits that you qualify for at CanadaBenefits.gc.ca. Tell it your province of residence, and head over to the Benefits Finder. You'll be asked a few questions and then be given a nice list of applicable benefits. Each benefit is marked as either federal or provincial.

Using this site, you can make sure that you are getting all the benefits for your current situation, and you can also use it see what you may be qualified to receive in hypothetical situations. Use the tool to plan ahead for events like the birth of a child so that when that event happens and you're busy waking up at 3am to change diapers, you won't need to also scramble to learn about and apply for (or put off for a few years) the benefits that you are entitled to.

Tax Terminology for Beginners

In conversations amongst my colleagues and friends, I've found that many people are not really aware of some of the basic terminology used in a tax return. While it's certainly not required to know all the terms used in the tax code, having basic knowledge of the meaning of the numbers you are calculating can clear up what is actually going on in your tax return. So here's my short list of tax terminology for beginners:

Total Income - Your gross income, before any deductions. Includes income from employment, investments, pensions, and government benefits.
Net Income - Your total income, after certain deductions have been applied. This number is used for determining eligibility for income-tested benefits, but is not used to calculate your personal income tax since it still contains some non-taxable income.
Taxable Income - Your net income, minus non-taxable income. Used to calculate your personal income tax.
Deduction - An expense that you declare (claim) on your tax return that is subtracted from your income when calculating your net income and taxable income. By reducing your taxable income, you reduce your tax paid.
Tax credit - A tax credit is applied directly to tax owing, reducing the amount you owe. This differs from a deduction in that a deduction reduces your taxable income.
Non-refundable tax credit - A tax credit that is not paid out as cash to you if it reduces your taxes owing to below zero.
RRSP - A plan provided by the government under which you can place investments that will grow tax-free. An RRSP is not a specific investment, or account, but acts like an umbrella. The size of your umbrella (contribution limit) is set by the CRA and anything (that is RRSP-eligible) that you put under it that fits in your contribution limit grows tax-free.
Adjusted Cost Base (ACB) - The cost of an item. This includes your purchase price, and costs related to the purchase. If you purchase the same item on more than one occasion, add the additional purchase prices and costs for those purchases. In a mutual fund (or ETF), if you receive distributions that are a Return of Capital, this will reduce your ACB, since your money is effectively being returned to you. Use the ACB to calculate your capital gains or losses when you sell the item.

Tax Refunds Cost You Money

Around this time of year, most people look forward to a nice big tax refund cheque from the CRA. The average refund for 2007 was $1440, a pretty substantial amount. Plenty of people (including financial advisors) will suggest treating yourself to something nice. $1440 will buy you a pretty nice TV, for example. But let's think about where that money came from first.

The government is not giving you free money. It's actually returning your money. Money that you overpaid through the year. In fact, because you overpaid, you've given the government a free loan and you didn't even get to earn any interest on it. So getting a big refund is actually to the government's advantage, because they certainly are getting a better-than-zero return on the cash you've graciously lent them.

One argument in defense of tax refunds is that they are like a forced savings, taking money out of your hands that you might otherwise have spent. Well, if you need to be on a forced savings plan, why not set one up yourself that sends regular deposits from your chequing account over to a high interest savings account or a money market fund. At least that way the money is working for YOU, and is way more liquid (should you really need it) than waiting for a cheque once a year.

It's probably to your advantage to actually owe a little bit on your tax return. However, you will need to budget for the amount owing at tax time. In the end, though, the fairest result would be to have no refund and no amount owing.

If you find yourself regularly getting a large refund, you can fill out form T1213 to request to have tax deductions reduced.

So if you get a refund this year, before you go and spend it, remember that it's not free money, and it's not a bonus. It's cash that you should have had in your hands already. Cash that you should have been able to put to work for yourself. Use the money like it was already yours, except that it was put away in an account earning you 0% and locked up until a few weeks after you file your return.

Preparing to Invest: Get To Know The Available Account Types

RRSP, RDSP, RESP, TFSA, RRIF, DPSP! There are many types of accounts/plans available to help you grow your money faster. Get to know how they work, so you can make the best use of them and allocate your investments to the proper accounts from the get go.

Let's look at the RRSP and TFSA since they are probably the most common. The main benefit for both of the accounts is that growth in the accounts are not taxed while they stay in the plan. How about some of the differences?

• Contributions to an RRSP are tax deductible while TFSA contributions are not.
• Withdrawals from an RRSP are taxed as income while TFSA withdrawals are not taxed at all.

These two points mean that if you expect your tax rate to be lower after retirement, you will pay less tax using the RRSP. If the opposite is true and you expect your tax rate to be higher after retirement (not as likely), then the TFSA is more advantageous in this respect.

But that's not all! RRSP withdrawals before retirement incur an early withdrawal penalty while TFSAs do not. Check out the withholding tax chart for early RRSP withdrawals. (Note these are not exactly your final tax rates on these withdrawals. You might think that if you make 3 withdrawals of $5000 that you will be taxed only 10% instead of 30% on a lump sum withdrawal of $15,000, but since these withholding taxes are estimates, you will end up with a huge tax liability at tax filing time when your final tax rates are calculated.)

As you can tell, there are many rules and eligibility requirements. Get to know the different account types so that you can make good use of the benefits available!

In the general case (and remember, none of us is average, so adjust for your own situation!), for someone saving for retirement, I would recommend filling up an RRSP first. Of course, top up both accounts every year if you can!

An Example of Allocating Holdings to Minimize Taxation

As a follow-up to yesterday's post on taxation of different income types, I want to go through an example so that you can see how one might think about where (RRSP, TFSA or taxable accounts) to hold different funds in your portfolio.

Let's consider what happens if you decide on an asset allocation of 25% each in the following types of index funds:

• Bonds
• Canadian Equities
• US Equities
• EAFE Equities

Let's also say that you have RRSP room for 50% of your portfolio, and the other 50% will have to go into your taxable account. Where would you put each of your funds? Let's look at the general income characteristics for each of these funds. Again, I am thinking in terms of index funds. Actively managed funds will have different tax profiles.

Bonds count as interest income and are fully taxed at your marginal rate.

Canadian Equities, when in an index fund, generally produce dividends and small capital gains. (In an actively managed fund, expect higher realized capital gains for which the tax liability is passed on to you.)

Similarly, the US Equity fund also generates dividends and some small capital gains, but these are considered to be from foreign sources.

Finally, the EAFE (roughly the rest of the developed world) Equity fund, since it covers a (generally) more volatile index, will probably generate more capital gains, as well as some dividend income. As with the US Equity fund, this income is considered to come from foreign sources.

In my opinion, and I'm no tax specialist, I would definitely put the Bond fund into the RRSP since its interest income would otherwise be taxed at your full marginal rate. The Canadian Equity fund would go into the taxable account to take advantage of the reduced tax rates on Canadian dividends and capital gains.

It's a bit of a toss-up between the US Equity fund and the EAFE fund, but I would put the US Equity fund into the taxable account and the EAFE fund into the RRSP since I believe that the US Equity fund will trade less and therefore generate fewer realized capital gains tax liabilities.

RRSP: Bond fund, EAFE fund
Taxable account: Canadian Equity fund, US Equity fund

Strategically allocating your holdings in your taxable and tax-sheltered accounts will help ensure that no matter what earnings you make, you actually keep the highest percentage for yourself as possible.

Managing Taxes on Your Investments

If you're new to investing or taxes, or have never done your own taxes, you may not know that different types of income are taxed at different rates. Your salary is taxed at your regular income rate (which is a progressive system in Canada--the first X dollars are taxed at a certain percentage, and the next Y dollars are taxed at a higher percentage, and so on). The tax rate on your last dollar (i.e. the highest tax level that you hit) is your marginal tax rate.

How does this relate to your investments? Investment income can be grouped into 3 basic categories:

• Interest
• Capital Gains
• Dividends

Interest is taxed at your marginal tax rate. Capital gains and dividends, on the other hand, have some advantages in that they are taxed at less than your marginal rate. TaxTips.ca has charts of this information, which varies by province. Here is the chart for Ontario and British Columbia.

Capital gains tax is calculated by taking half of the taxable amount, and then applying your marginal tax rate. In other words, capital gains are taxed at half the rate of interest income.

Dividends are a bit trickier since there is a tax credit involved, but as you can see from the chart on TaxTips.ca, they are taxed generally at the lowest rate.

Keep in mind that income from foreign sources is generally taxed as regular income. The type of income--interest, capital gains, or dividends--does not matter for foreign sources. You may want to check for tax treaties with other countries to see if there are exceptions in your case.

I won't go through the exact rates or methods of calculation since they change from time to time, but you can see that some income is tax advantaged, and some (interest and foreign) is not. For example, suppose you could earn 3% interest income in a high interest savings account, or earn 3% dividend yield on a stock (both in a taxable account). You will get to keep more of your earnings from dividends than from the interest income. It is important to keep in mind that it doesn't really matter how much you earn on your investments. What matters is how much you keep.

For those of you who have all of your investments sheltered in an RRSP (or TFSA), this discussion does not really matter--all of your earnings are tax-free (and able to compound tax-free). If, however, you have your investments split between tax sheltered accounts and taxable accounts, you can maximize the money you keep by strategically placing certain types of investments in the RRSP, and leaving the rest in your taxable account. We'll look at an example of this tomorrow.