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What types of "tax-friendly" investments are available outside of an RRSP?

The amount of tax you pay on an investment depends on what type of investment it is. You can minimize what tax you will pay if you concentrate on those tax-favored investments.

There are three different tax rates for interest, capital gains and dividend income.

You will pay the most tax on interest income. It's taxed at your full marginal tax rate -- just like your employment income. So if you are in the 40% tax bracket and have $100 of interest income, Revenue Canada would receive $40 and you would keep $60. Interest income is generated by investments like bonds issued by the federal government, Canada Savings Bonds, GICs, term deposits, money market mutual funds and the interest income on bond mutual funds. You end up with a capital gain when you sell an investment, such as a stock or bond for more than you paid for it. You pay tax on just 50% of your capital gain. If you received a $100 capital gain, you would pay tax on only $50. If you were in the 40% tax bracket, you would pay $20 in taxes and keep $80.

If you received $100 of dividend income from a Canadian corporation, you would pay about $25 in tax and keep roughly $75, assuming you were in the 40% tax bracket. Dividends are paid on a company's preferred shares or common stocks.

You should also be aware that when you have to pay taxes depends on the investment. In the case of interest income, you generally have to pay taxes each year. Capital gains are usually payable only when you actually realize the gain by selling the investment for more than you paid. As long as you don't sell, your capital gains aren't taxed. If you bought a stock in 1995 for $10 a share and didn't sell it until 2000, you wouldn't have to pay any tax on the rising value of that stock, assuming its value rose, until you actually sold it. You can delay paying tax by buying stocks and avoiding selling for an extended period. Dividends are also usually taxable in the year they are paid to you, but the rate is less than for interest income, so buying dividend-paying stocks would help limit your taxes.

Although you want to keep taxes in mind, you should focus on picking good investments. Avoid the mistake of choosing investments just because they may be taxed at a favorable rate. Your mix of investments should reflect your investment objectives.

If you only consider taxes, you might decide to put all your money into stocks so that most of your investment income would come from capital gains or dividends. But stocks, in the short-term in particular, also carry more risk than lower-taxed investments like interest-paying bonds or GICs. Having all your money invested in stocks may mean you would have more risk in your portfolio than you are really comfortable taking.

A well-diversified portfolio will have a mix of investments, which means you will likely have some of all three types of income.

If your investments are held in mutual funds, the taxes you pay will depend on the type of income that is earned by that mutual fund. Therefore, if the mutual fund invests in stocks, which it sells for a profit, you will be liable for the tax on your share of that profit in the year the stocks were sold.

Most mutual funds that invest in stocks distribute capital gains earnings to investors once a year - usually in late December. So if you bought units in such a fund late in the year, you could end up paying tax on those capital gains without having benefited from the gain. To avoid that problem, don't invest a lot of money into a fund late in the year if that's when it pays out capital gains.

A mutual fund that buys and sells stocks often -- rather than buying and holding -- could generate a substantial tax bill. Another way to minimize your capital gains tax bill on a mutual fund that invests in stocks is to buy an index stock fund. Such a fund buys stocks that make up that index, so it doesn't do a lot of buying and selling. A Canadian stock index fund, for example, might buy stocks from among those that make up the Toronto Stock Exchange 300 composite index.

You can also buy unit investment trusts. Similar to a mutual fund, the trust buys particular, identified stocks so you know what you are buying. It holds those stocks for a set period - perhaps five years. That minimizes the possibility of facing an annual capital gains bill. Earnings on investments held inside your RRSP aren't taxed until they are withdrawn. Because of that, you would probably want to put your maximum contribution limit into your RRSP each year.

If you can manage to also invest outside an RRSP, you might want to avoid holding interest-generating investments outside your RRSP to minimize tax. You should restrict your non-RRSP holdings to capital gains-generating or dividend-paying investments. In the case of capital gains, this would have the added advantage of allowing you to offset capital gains against capital losses to reduce your tax bill.

If you have capital losses inside your RRSP, they can't be used to offset capital gains on your non-RRSP holdings. This is an argument for holding your riskier investments outside your RRSP. Consider seeking professional investment and tax advice to help you pick investments that meet your needs.