Reducing taxes for fixed income investors – Part I

Over the last couple of years, higher interest rates have caused many fixed income and GIC investors to face significantly larger tax bills on the interest earned in their non-registered portfolios.

In a high interest rate environment, newly issued bonds and GICs must pay higher interest rates to attract investors. The good news is that this typically increases these holdings’ go forward returns.

The following table illustrates how interest rates have impacted GIC rates over the last 5 years.

Source:  The Bank of Canada

For investors with sizeable, fixed income positions in non-registered accounts, the increased taxes can be substantial. In Ontario, the top marginal tax rate is 53.53%. If someone in this tax bracket purchased a $300,000 1-year GIC on June 5^th, 2024, for 4.00%, when this GIC matures, they’ll receive $12,000 in interest income. Of this sum, $6,424 will be lost to taxes. If instead they purchased a $300,000 1-year GIC on June 9^th, 2021, they’d have received a meagre $750 in interest, $401 of which went to taxes.

A tax refresher for non-registered accounts

There are various types of possible investment distributions within a non-registered account, with some being more tax-efficient than others:

Source:  Duplicated from this RBC table 

Fortunately, even if you’ll continue to hold a large portion of your non-registered portfolio in fixed income investments, there are strategies available to reduce your portfolio’s taxes going forward. This post highlights two options.  A follow up post will include 3 more.

Increase your equity exposure

For most investors, their target asset allocations (i.e. their target cash/fixed income versus equity allocations) aren’t stagnant. There is typically some flexibility in the percentage they can comfortably allocate to each asset class.  For instance, an investor with a target asset allocation of 40% in cash/fixed income investments and 60% in equity might be comfortable deviating 10% in either direction.

Your target asset allocation is based on a variety of factors, the primary ones being your investment time horizon, investment objective and risk tolerance. Shorter time horizons and lower risk tolerances are better aligned with a heavier allocation to cash and/or fixed income. Though target asset allocations don’t get nearly as much airtime as security selection, they are fundamental in properly structuring your portfolio. Your asset allocation has a significant impact on both the expected volatility of your portfolio and its rate of return expectations.

For medium to long term investment horizons, by modestly increasing the percentage of your portfolio in equities, you can generate more tax-efficient returns. As outlined in the above table, equities primarily generate earnings in the form of capital gains and dividends, which are typically more tax-efficient than the interest income generated by bonds and GICs. Another advantage of equities is that they tend to outperform fixed income investments over the long term. This is an appealing trait, as long as you have the time (and the stomach) to wait out shorter term volatility.

Buy corporate class mutual funds

Mutual funds can be legally structured as either a trust or a corporation. What’s the difference and how does it impact you as a unit holder?

In short, corporate class mutual funds are particularly appealing for non-registered portfolios. Using a corporate class structure, numerous individual mutual funds are grouped together so that they can be taxed as a single corporation. This legal structure creates tax planning opportunities; losses in one mutual fund can be used to offset gains in another mutual fund, creating tax savings that get passed onto unit holders.

Corporate class mutual funds are unique in that they are only allowed to distribute dividends from Canadian stocks or capital gains to unit holders. Both types of distributions are more tax-efficient than ordinary income such as interest. So, what happens if a corporate class mutual fund generates interest or foreign dividends/income? These proceeds can’t be flowed through to the unit holder; they get trapped within the corporation. If the corporation doesn’t have sufficient expenses to fully offset these earnings, the corporation pays tax on these earnings at a high corporate tax rate.

In contrast, with mutual fund trusts, distributions can be paid out to unit holders as interest/regular income, dividends or capital gains.

By investing in a corporate class mutual fund instead of an equivalent mandate that’s structured as a mutual fund trust, non-registered investors typically receive higher after-tax returns on distributions. Unfortunately for fixed income investors, there are very few fixed income corporate class mutual funds available. This scarcity makes sense; fixed income investments primarily generate returns in the form of interest. Because corporate class mutual funds can’t pass this interest onto unit holders, fixed income mandates aren’t well-suited to a corporate class structure; interest income would get trapped within the corporate class structure and taxed at a high corporate rate, instead of being flowed through to the unit holders, most of whom would pay taxes at a comparatively lower tax rate.

Fortunately, for investors who can handle some equity exposure, there are numerous balanced and equity mutual funds available in a corporate class structure.

If you’re interested in purchasing corporate class mutual funds, we recommend that you first start by assessing a mutual fund based on how well its mandate suits your needs. Only after you’ve found the best investment(s) for your objectives do we recommend investigating if a corporate class version is available. If you narrow your search parameters to corporate class investments only, it’s easy to miss out on better investment mandates that might only be available in as a mutual fund trust.

Don’t let the tax tail wag the dog

Despite the unpleasantness of paying taxes and the numerous strategies available to minimize taxes, it’s important not to lose sight of the big picture. In all but the rarest of cases, taxes should not be the primary driver of your investment strategy. Instead, the tax implications of your investments should be considered only after your investment objectives, investment time horizon and the suitability of potential investment products have been considered. After all, it’s always better to pay taxes on investment earnings than to owe no taxes because you experienced losses in your portfolio.

Our next post will include 3 more methods of reducing investment income tax.