Unlocking tax alpha: Strategies for enhancing after-tax returns

In today's investment landscape, maximizing returns involves more than just selecting high-performing assets. It also requires a keen understanding of tax implications. Tax alpha, the concept of enhancing portfolio performance through strategic tax management, offers a powerful yet often underutilized approach for investors. By employing tax-efficient strategies, investors can improve their after-tax returns, ensuring that more of their hard-earned money stays invested and continues to grow.

Tax alpha can be achieved using a range of strategies, from leveraging registered plans and selecting low-turnover and low-distribution funds to customizing asset allocations for tax efficiency and considering direct security holdings for larger portfolios. By understanding and implementing these tax-efficient techniques, investors can optimize their portfolios, mitigate tax costs, and ultimately achieve better financial outcomes.

Use registered plans first

Registered plans such as tax-free savings accounts (TFSAs), registered retirement savings plans (RRSPs), and registered retirement income funds (RRIFs) offer a tax-sheltered environment where income and capital gains aren’t subject to tax as they’re earned or realized. Despite their advantages, these plans are often underutilized. Many Canadians don’t maximize their contributions, potentially missing out on substantial tax savings. By prioritizing registered plans, investors can achieve tax-efficient compounding returns. For instance, funds generating interest income or fixed taxable distributions are ideal candidates for inclusion in an RRSP or RRIF.

These plans provide enough options to meet various savings goals and should address the tax efficiency needs of most investors. The TFSA may be the most flexible of the registered plans, allowing investors to save for any goal over any time horizon. Investment earnings and withdrawals are tax-free, which means they don’t impact income-tested benefits. Withdrawals are added to the following year’s contribution room, allowing for future re-contribution towards the next savings goal. This is a versatile option compared with a taxable investment account.  

Lower portfolio turnover and lower distribution funds for personal and corporate taxable accounts

For individual investors, it's important to consider funds with lower portfolio turnover (portfolio managers trade less frequently) to minimize taxable distributions. Asset allocation or fund-of-funds that align with these principles can serve as simple, out-of-the-box solutions for assets in taxable (non-registered) accounts. Some exchange traded funds (ETFs) also offer lower turnover and distribution options with traditionally lower fund costs. From a tax perspective, low turnover funds should be considered over funds with higher trading activity, assuming other factors like investment risk and return remain the same.

Corporate class mutual funds which can lower taxable dividends by using the expenses and capital losses of one fund to offset the income and capital gains of another fund, can further enhance tax efficiency. Additionally, mutual fund corporations can’t distribute interest and foreign income, the least tax efficient types of income. These income sources are usually offset by fund expenses, maintaining tax efficiency at the fund level. When such income is offset by fund expenses, it’s effectively converted into capital gains. These capital gains are then deferred until the investor sells their shares.

Canadian Controlled Private Corporations (CCPCs) have access to a small business deduction (SBD) of $500,000. The provincial SBDs in Saskatchewan, Prince Edward Island and Nova Scotia are higher ($600,000, $550,000 and $650,685 respectively). Active business income (ABI) up to the SBD is taxed at low tax rates. However, investment income including capital gains, can result in a reduction of this SBD¹. Once this income (known as adjusted aggregate investment income (AAII)) reaches $50,000, the SBD is reduced by $5 for every $1 of AAII ($6, $5.50 and $6.51 for every $1 in Saskatchewan, PEI and Nova Scotia respectively). When AAII reaches $150,000, the SBD is $0. The same low turnover and low distribution funds mentioned previously provide the tax benefits of less taxable investment income and preservation of the SBD for lower tax on ABI.

Custom asset allocation: tax-efficient funds

Investors can achieve tax efficiency by customizing their asset allocation using individual funds that align with their risk and return profile. Canadian equity-focused funds are advantageous due to the favorable tax treatment of capital gains and eligible dividends. Low or no dividend funds, including mid or small capitalization companies and equity growth funds, can also minimize taxable income. Alternative investments, such as liquid alternative funds (aka liquid alts) with lower turnover, may offer additional tax-efficiency. While the availability of fixed-income funds focusing on discount bonds is limited, any potential options should be considered. Since discount bonds are sold below their maturity value, if held to their maturity, they will generate a capital gain, in addition to their interest income. When bonds are bought at par (their face value) and held to maturity, they won’t generate a capital gain, since they mature at their par value. They will only generate interest income, which is fully taxable.

Direct security holdings for larger non-registered portfolios 

For investors with larger non-registered portfolios, holding securities directly can offer greater control over tax efficiency. Separately Managed Accounts (SMAs) allow for further customization of asset allocation, enabling investors to build portfolios with individual securities rather than exclusively with funds or ETFs. This approach allows for better control of portfolio turnover and strategically realizing gains and losses on a security-by-security basis. High-net-worth clients, who are likely to have maximized their registered plans, stand to benefit the most from this level of tax-efficient customization.

Capital gains and Canadian dividends

Strategically focusing on capital gains and Canadian dividends can further enhance tax efficiency. Funds generating capital gains through activities like currency trading or liquid alternatives that replace interest income with capital gains can be beneficial. ETFs specifically designed to generate Canadian dividends, offer another layer of tax savings thanks to the dividend tax credit. By emphasizing Canadian dividend income and capital gains, investors can optimize their portfolios for better after-tax returns.

Boosting long-term growth through tax efficiency

By understanding and implementing these tax-efficient strategies, Canadian investors can significantly enhance their after-tax returns. Utilizing registered plans, selecting low-turnover and low-distribution funds, customizing asset allocations, and considering direct security holdings for larger portfolios are all effective methods to unlock tax alpha. Financial advisors play a crucial role in guiding their clients through these strategies, ensuring that their investment portfolios are optimized for tax efficiency and long-term growth.

1 The SBD reduction applies to the federal limit and all provincial limits except Ontario and New Brunswick which aren’t reduced by investment income.