Smart tax decisions for Canadian investors with non-registered accounts
Once you’ve maxed out your TFSA and RRSP, the next logical step is to start investing in a non-registered account. But unlike registered accounts, where tax is deferred or eliminated, every dollar of income in a taxable account can cost you. Unfortunately, the types of investments people naturally gravitate toward – high-yielding dividends, interest-heavy bond funds, or even leverage – can introduce avoidable tax drag and unnecessary risk.
This article explores three common traps in taxable investing and provides practical alternatives to consider
The Illusion of “Tax-Efficient” Dividends
Many investors seek out dividends for income, under the impression that they are getting a bonus on top of their portfolio’s growth. But in taxable accounts, dividends are not free money. They’re simply a transfer of value from the company to the shareholder – and that transfer triggers a tax bill in the year it’s received. A better analogy is this:
Receiving a dividend is like taking money from one pocket and putting it into the other – while paying the government a fee for the transaction.
Think about it – if you have a business bank account, and you pay yourself some dividends and salary from it to your personal account, your net worth didn’t change. You just now have to pay tax on the dividend.
This is an over-simplified example, but it’s directionally accurate.
What makes this more misleading is that many dividend-paying companies also share other traits – such as being smaller in size, lower-priced relative to their earnings (seen as better value for your money), or more profitable – that academic research has linked to higher expected returns. So, to be clear, I am not saying avoid dividend paying investments, just that the dividend yield isn’t the most important characteristic to focus on.
For instance, for many of my clients I take an approach that is based on the Fama and French’s multi-factor models have shown that size, value, and profitability help explain long-run performance, not dividend yield itself. So while dividend-paying portfolios may appear to outperform over time, it has been proven that the dividend isn’t what’s driving the return.
The risk for investors is that chasing dividend yield often leads to overly concentrated portfolios – particularly among Canadian equities – which reduces diversification and increases exposure to specific sectors like financials or energy. That overexposure adds uncompensated risk, and it’s rarely necessary. I do want to reiterate though – I am not saying dividends are bad, you can probably have a pretty good outcome investing in them over a long period of time, and if the monthly income mentally helps you stay invested during downturns, that should not be discounted. The best plan is one you can stick to. It is slightly suboptimal when combing through the academic research and comparing it to a more factor based approach. From a planning perspective, focusing on total return is far more effective.
Whether you draw income from dividends or from selling a portion of your portfolio, the outcome can be nearly identical – but the tax treatment and flexibility are often better when total return is prioritized.
Not All Bonds Are Taxed the Same
While bond investments are a critical tool for managing portfolio risk, they are also among the least tax-efficient investments you can hold in a non-registered account. Interest income is fully taxable at your marginal rate, which can exceed 50% for high-income earners in British Columbia.
That said, there are better and worse ways to hold bonds in a taxable account. The key lies in understanding the difference between premium and discount bonds.
Bonds are sometimes priced at a premium due to offering interest rates higher than market rates – this higher interest income may look attractive at first, but it comes with a downside. These bonds tend to mature at a capital loss, and that loss can’t be used to offset the interest income you’ve received along the way. The result is a tax mismatch that reduces your after-tax return.
Discount bonds, on the other hand, are purchased below face value and generate a portion of their return as a capital gain. Since capital gains are taxed more favourably, this structure offers better after-tax outcomes in taxable accounts. Fortunately, there are discount bond funds available in Canada that are designed specifically with this principle in mind. These funds aim to reduce interest income and increase the proportion of return classified as capital gains, making them a more tax-conscious choice for non-registered portfolios.
Borrowing to Invest: Not Always What It Seems
Using leverage (borrowing to invest) can accelerate returns, but it also amplifies losses. In a taxable account, the strategy can be particularly complex.
From a tax standpoint, interest on investment loans may be deductible – as long as the borrowed funds are used with the intent to earn income and the investment is clearly tracked. That means setting up separate accounts, avoiding partial withdrawals, and maintaining clear records for CRA
But tax deductibility alone shouldn’t justify leverage. The real question is whether the potential reward is worth the increased risk and complexity. Responsible use of leverage should meet a few criteria. Debt payments should be comfortably affordable, even if markets decline. The investor should have experience through at least one real bear market, and a portfolio aligned with long-term goals and ability to withstand volatility. Ideally, leverage should not exceed 30% of net worth or 50% of liquid assets. Borrowing rates should be relatively low, and the probability of succeeding when leveraging a well diversified portfolio is statistically higher after a market downturn (lower market valuations lead to higher expected returns in the future).
Even then, the actual benefit may be modest. In many cases, leveraging a portfolio might increase after-tax wealth just enough to retire one year earlier – not ten. That may or may not be worth it, depending on the person.
For those who do proceed, simplicity and discipline are essential. Using a single asset-allocation fund avoids triggering partial sales and makes tracking easier. It also avoids the risk of accidentally making a portion of your interest expense non-deductible – which can happen if you sell some of the investment and don’t reinvest it.
The Big Picture
Tax planning in a portfolio isn’t about chasing loopholes or optimizing for a single year. It’s about structuring your investments to support long-term goals with fewer surprises and better after-tax outcomes. Whether it’s resisting the allure of dividends, choosing the right type of bond fund, or avoiding unnecessary complexity in a leveraged strategy, the most effective decisions are those made with planning – not gut instinct.
“Hope” is not a strategy!
The best tax strategy is one that fits seamlessly into the rest of your financial plan. If you’d like help reviewing how your corporate, or non-registered investments are structured – or if you’re exploring whether strategies like discount bond funds, asset-location optimization, or responsible leverage might make sense for you – feel free to reach out.
Disclosures:
Important information about mutual funds is found in the Fund Facts document. Please read this carefully before investing. Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Mutual funds are not guaranteed, their values change frequently, and past performance may not be repeated. Unit values and investment returns will fluctuate.
The information provided is based on current laws, regulations and other rules applicable to Canadian residents. It is accurate to the best of our knowledge as of the date of publication. Rules and their interpretation may change, affecting the accuracy of the information. The information provided is general in nature and should not be relied upon as a substitute for advice in any specific situation. For specific situations, advice should be obtained from the appropriate legal, accounting, tax or other professional advisors.
