"A dollar is not necessarily a dollar” Insight on Taxation of Investment Income

Depending on what category your investment income falls into, there are different, and sometimes beneficial, tax treatments to the different categories. Investors are often focused on the bottom line, but rarely are they focusing on the after-tax bottom line returns. At Northland Wealth Management we strive to improve after-tax returns for our clients. After all, it is not what you make on your investments; it is more about how much is left in your pocket after the tax man has taken his share.

Income from investments held in non-registered accounts is taxed at different rates based on whether it comes from interest, dividends, or capital gains.

Interest income is taxable annually even if it hasn’t been paid out, such as with accrued interest. Capital gains, or profits made from the sale of securities, are taxed at a 50% inclusion rate. This means that only half of the amount gained is taxable. Example: If you sell a share for $20 that cost you $12, you will have a capital gain of $8. Therefore, only $4 of the capital gain is taxable. Dividends are payments made by a company to shareholders based on the proportion of the shares they hold. Dividends are taxable in the year in which they are declared and entitle shareholders to a tax credit on Canadian dividends, which effectively reduces the percentage of income tax payable.

The inset chart – Taxation of $1.00 of Income by Source, outlines the effective difference between after-tax returns of the various sources of investment income. Values below have been calculated using approximate taxation rates as of July 15, 2011 at a base income tax rate of 46% on income. Taxation rates vary from province to province, yet the message conveyed is consistent. The taxation of dividend and capital gain income from equity investments is in large part advantageous to that provided from interest bearing investments.

In addition, when looking from a pure taxation standpoint, one must also take into consideration the allocation of investment funds between registered and non-registered accounts. Registered plans such as RSP’s and RIF’s, as well as Tax-Free Savings Accounts (TFSA’s), offer tax-deferred and tax-sheltered growth respectively. Any income taken out of a registered plan (RSP or RIF) is considered fully taxable at the time of withdrawal, similar to the way your salary from your employer would be taxed, regardless of the original source of income (i.e. dividends and capital gains). TFSA’s offer the advantage of providing tax-free growth, meaning any funds removed from a TFSA are not subject to any taxation. As a result, allocation of interest bearing investments to registered accounts, and dividend paying securities to non-registered accounts, can often provide for a higher after tax-return.

For the non-registered portion of an investor’s portfolio, dividends and capital gains are not the only way to reduce taxation. Capital distributions, typically provided by specialized alternative investment solutions, can also prove to be effective in maximizing after-tax returns by means of tax deferral.

Although you never want the tax tail to wag the investment dog, investors should always be focused on the long-term after-tax return as it will have the greatest impact on their portfolios.

To learn more about how the various taxation options are applicable to your portfolio, please give us a call.