How I am building a tax efficient investment portfolio in Canada (& how you can too)

One of the most important personal finance moves you can make is starting an investment portfolio, but if you’ve never done it before, it can seem intimidating. I come from the school of thought where savings is a 'good habit', and allocating budgets for 'needs' and 'wants' is paramount to keeping a check on expenses.

So where does 'investing' figure in all of this?

If you would have read my earlier musings on Credit Score in Canada, you would know that my approach to money and personal finances in general is conservative. But, when it comes to building my investment portfolio - 'Growth' is my mantra!

Investment Portfolio and Risk Tolerance

One of the things I took into consideration when creating my investment portfolio was my personal risk tolerance. Given that I am Single and don't have anyone dependent on me, as well as having a long way to retirement, my risk tolerance (the ability to accept investment losses in exchange for the possibility of earning higher investment returns) is HIGH. But that might not be the same case for you...

Your risk tolerance is tied not only to how much time you have before your financial goal such as retirement, but also to how you mentally handle watching the market rise and fall. If your goal is many years away, you have more time to ride out those highs and lows, which will let you take advantage of the market’s general upward progression.

Let's Understand the 7 Types of Investment Instruments

• Cash Instruments: Include savings and checking accounts, certificates of deposit and money market accounts.
• Bond Issues: Originate from companies and governments to raise capital for operational and strategic needs. Bond investors receive regular interest payments and get the principal back on maturity.
• Equity Investments: Companies issue stock to raise capital for various needs. Stocks trade on regulated exchanges, such as the NYSE, NASDAQ, TSX or on over-the-counter markets. Investment portfolios benefit from rising stock prices but suffer during periods of market volatility.
• Mutual Funds: They offer diversification at reasonable costs because the fund companies are able to spread the fees and expenses over a large asset base. Stock funds invest in stocks, bond funds invest in bonds, and balanced funds invest in a mix of stocks and bonds. There is further specialization within these categories.
• ETFs: Exchange-traded funds are similar conceptually to mutual funds, except that they trade like stocks on exchanges and track market indexes and sub-indexes. ETFs offer convenience and sector diversification at lower costs than regular mutual funds.
• Commodities and Precious Metals: You can invest in gold, silver and other commodities. Commodity prices are volatile, and there is the risk of significant capital loss in a short period. Individual investors can gain exposure to this sector cost-effectively through commodity mutual funds and exchange-traded funds.
• Real Estate: Residential and commercial real estate investments can offer investors attractive rates of return, especially during periods of economic expansion.

Horses for Courses: RRSP + TFSA + Non-Registered

So now that you have some understanding of what are the types of investment instruments available (the horses), let me tell you how and where I am spreading these out (the courses) as part of my investment portfolio.

Firstly, I am invested across all the 7 types of investment instruments mentioned above (directly or indirectly). A diversified investment portfolio not only spreads the risk, but also allows for compounding effect of investments to truly reap rich dividends in the long run.

• RRSP

I primarily ONLY invest in the U.S. Equity Investments (Both Growth & Dividend Stocks) and U.S. ETFs through my RRSP.

Here's why:

The U.S. withholding tax rate charged to foreign investors on U.S. dividends is 30%, but this amount is reduced to 15% for taxable Canadian investors by a tax treaty between the U.S. and Canada.

Under the Treaty, there is a special exemption from U.S. withholding tax on interest and dividend income that you earn from U.S. investments through a trust set up exclusively for the purpose of providing retirement income.

These trusts include RRSPs, RRIFs, LIRAs, LIFs, LRIFs and Prescribed RRIFs. They do not include RESPs, TFSAs and RDSPs.

The special exemption is not currently available in any other tax treaty that Canada has with other countries. Therefore, interest and dividends you receive from investing in non-U.S. securities may be subject to foreign withholding tax. Certain types of U.S. investments you hold in an RRSP do not qualify for the Treaty exemption and will be subject to U.S. withholding tax. For example, if you hold a Canadian mutual fund or ETF that invests in the U.S. market in your RRSP/RRIF, there will be U.S. withholding tax on the dividends that you cannot recover.

• TFSA

I primarily ONLY invest in the Canadian Equity Investments (In Growth Stocks), Mutual Funds (In High Growth Sectors), Commodities and Precious Metals (In Mutual Funds), Bond Issues and Canadian ETFs through my TFSA.

Here's why:

A Tax Free Savings Account (TFSA) is a registered investment or savings account that allows for tax free gains. It is very flexible and highly advantageous for "tax free" growth of all my investments.

A TFSA is what’s often referred to as a “tax-advantaged account,” meaning the government provides tax breaks.

• Non-Registered

I primarily ONLY invest in the Canadian Equity Investments (In Dividend Stocks & Penny Stocks) through my Non-Registered account.

Here's why:

Non-registered accounts are investment accounts offered by banks and financial service providers in Canada, as well as mutual fund companies.

These accounts offer a lot of flexibility with consistent liquidity and no contribution limits, as well as a tax benefit. Dividends are taxed on a gross amount but benefit from a dividend tax credit.

Capital gains from investments in non-registered accounts are taxable at only 50% of the account holder’s marginal tax rate. However, interest income is fully taxable at the account holder's marginal tax rate.

A Canadian dividend receives special tax treatment, due to something called the Dividend Tax Credit (DTC). The federal and provincial governments incentivize Canadians to invest in Canadian stocks by charging a preferential low tax rate on Canadian dividends.

BONUS TIP

If you experience an investment loss, you can take advantage of it by decreasing the tax on your gains on other investments. Say you own two stocks, one of which is worth 10% more than you paid for it, while the other is worth 5% less. If you sold both stocks, the loss on the one would reduce the capital gains tax you'd owe on the other. Obviously, in an ideal situation, all of your investments would appreciate, but losses do happen, and this is one way to get some benefit from them.

If you have a capital loss that's greater than your capital gain, you can use up to $3,000 of it to offset ordinary income for the year. After that, you can carry over the loss to future tax years until it is exhausted.

ALL IN: Maxing out RRSP & TFSA Contribution Limits

This is only my fourth year in Canada, and with my frugal lifestyle and high risk appetite I have continued to max out both my RRSP & TFSA contribution limits each and every year as well as build a diversified investment portfolio that's focused on the long term goal of achieving Financial Independence!

Hope this is a helpful resource for those starting out on their investment journeys in Canada as well as those who might be wanting to understand which investment instruments are ideal for their RRSPs and TFSAs respectively.

Until next time!??