Do-it-yourself investing can be more taxing than you expect.
It's a good idea to understand how taxes can affect your portfolio, says Justin Bender, a portfolio manager at PWL Capital Inc. in Toronto, who also advises DIY investors. For most DIY investors the issues are not necessarily that complicated, but there can be a big difference in your before- and after-tax earnings.
"In terms of the investment side, it does depend if you are just starting out," he says. "If you have an RRSP [registered retirement savings plan] or TFSA [tax-free savings account], really you just have to be aware of foreign withholding taxes."
These are the amounts held back if you have foreign stocks or certain funds that hold international equities, such as U.S. exchange traded funds (ETFs). The withholding is waived if you hold foreign stocks in an RRSP, thanks to tax treaties between Canada and the United States and other countries.
For non-registered accounts and TFSAs (the latter have no additional Canadian tax burden), the foreign withholding amounts are recoverable, but it depends on the fund and it can still end up costing you, says Mr. Bender: "There are ways around it, but the cost on a balanced portfolio can be between 0.15 per cent and 0.2 per cent [beyond any other fees]."
Taxes become more complicated for non-registered investment accounts.
"You also have taxes on the income," Mr. Bender says. "Canadian dividends are the most favourably taxed, but investors still have to watch out for the extent of the distributions."
For example, if you hold a Canadian stock or fund that distributes a large amount each year you may end up paying more tax on this distribution than you would in foreign withholding tax for a foreign fund.
"A lot of people are really obsessed with dividends," he says.
Another big tax issue that DIY investors should be aware of is how bond funds are treated by the tax system, Mr. Bender adds. Generally, "they shouldn't be holding them in their taxable accounts."
Bonds are one of the least tax-friendly asset classes," says Mr. Bender's PWL colleague Dan Bortolotti. "Most of their return comes from interest payments, which are taxed at the highest rate. They're even less tax-efficient when their market price is higher than their par value." These are called premium bonds.
"These premium bonds are taxed so unfavourably they can actually deliver a negative after-tax return. Unfortunately, because interest rates have trended down for three decades, virtually every bond index fund and ETF is filled with premium bonds."
Mr. Bender says some bond funds manage to avoid this unfavourable tax treatment, such as the BMO Discount Bond ETF and a strip bond ETF from First Asset. He also recognizes that it's important for DIY investors (and managed ones, too) to balance their portfolios with fixed income holdings; he suggests considering GICs, which never suffer capital losses and pay relatively low interest, attracting less tax.
When you sell a stock or fund at a profit, 50 per cent of the profit is taxable as a capital gain. This profit can be offset by capital losses from other sales, even if they were sold in previous years. This has tax implications when it comes time to rebalance your DIY portfolio – the process of selling off the underperformers and making sure you have the right mix of growth and safer holdings to match your risk tolerance – Mr. Bender says.
Many investors like to sell their dogs near the end of the year, to make sure they can record the capital losses to offset gains. "I prefer to rebalance throughout the year," Mr. Bender says.
There's no need for a herd instinct, he explains. With a year-end selloff, investors may be tempted to unload something just because it is temporarily down, rather than paying attention throughout the year and making sure it is something to be dumped.
DIY investors should keep track of the adjusted cost base of their investments, too, Mr. Bender says. The Canada Revenue Agency wants to know how much you paid for an investment so they can determine how much you gained or lost when you sell it, and tax you. Every time you add to or sell a stock or fund, or reinvest dividends to buy more, your cost base gets adjusted.
Do you need an accountant to handle all this? Maybe. You can DIY your taxes, but think about avoiding the hassle by hiring a professional, Mr. Bender says.