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Improving After-Tax Investment Returns

Updated: Jun 7

"A dollar is not necessarily a dollar” insights on the taxation of investment income

Monopoly board - Income Tax square - Pay $200

When it comes to managing investments, understanding how taxation impacts your returns is just as important as the investments themselves. Many investors focus heavily on the bottom line but often overlook the critical difference between pre-tax and after-tax returns.


At Northland Wealth Management, we specialize in optimizing after-tax returns, ensuring clients keep more of what they earn. After all, it’s not just about what you make but how much stays in your pocket after taxes.


The Taxation of Investment Income

Investment income held in non-registered accounts falls into three key categories, each subject to different taxation rules:


Interest Income

Interest earned, whether paid out or accrued, is fully taxable in the year it is earned. This includes income from bonds, savings accounts, and other interest-bearing investments.


Tip: Since interest income is taxed at the highest rate, consider holding these investments in registered accounts to shield them from immediate taxation.


Capital Gains

When you sell an investment for more than its purchase price, the profit is considered a capital gain. Only 50% of a capital gain is taxable. For example, if you sell a stock for $20 that you purchased for $12, you’ll have a capital gain of $8, but only $4 of that amount will be taxable.


Why it Matters: Capital gains offer one of the most tax-efficient ways to grow your wealth over time, making them an attractive component of any portfolio.


Dividends

Dividends, typically paid by companies to their shareholders, are taxed differently. Canadian dividends qualify for a dividend tax credit, which reduces the effective tax rate compared to interest income.


Pro Tip: By holding dividend-paying securities in a non-registered account, you can maximize the benefit of the dividend tax credit.


Understanding these distinctions is crucial for optimizing your tax strategy. The differences between the tax treatment of interest, capital gains, and dividends can have a significant impact on your after-tax returns.


Comparing After-Tax Returns

To illustrate how different types of investment income are taxed, take a look at the inset chart (Taxation of $1.00 of Income by Source). The chart underscores a key takeaway: equity investments generating dividends or capital gains are generally more tax-efficient than interest-bearing investments. While specific taxation rates vary from province to province, the overarching principles remain the same.


Leveraging Registered Accounts

Tax planning doesn’t stop at understanding income types. Allocating investments between registered and non-registered accounts can further enhance your after-tax returns:


  • Registered Retirement Savings Plans (RRSPs) and Registered Retirement Income Funds (RRIFs): These accounts provide tax-deferred growth, but withdrawals are fully taxable as income, regardless of the original source (e.g., dividends or capital gains).

  • Tax-Free Savings Accounts (TFSAs): Investments in TFSAs grow tax-free, and withdrawals are not subject to any taxation. This makes TFSAs ideal for holding growth-oriented or high-yield investments.

  • Strategy Tip: Place interest-bearing investments in registered accounts to shelter them from higher tax rates, while reserving non-registered accounts for dividend-paying securities and capital-gain-oriented investments.


Alternative Investments

For non-registered portfolios, dividends and capital gains aren’t the only tools for reducing taxation. Alternative investments, such as investments offering capital distributions, can provide significant tax deferral benefits, allowing you to defer taxes while enhancing after-tax returns.


Example: Specialized income structures within alternative investments can allocate a portion of returns as capital distributions rather than taxable income, reducing the tax burden.


Focusing on Long-Term After-Tax Returns

While it’s tempting to concentrate solely on gross returns, long-term after-tax returns are what truly impact your portfolio’s performance. By integrating tax efficiency into your investment strategy, you can achieve better outcomes over time.


Remember: It’s not about letting the “tax tail wag the investment dog.” Your primary focus should remain on long-term objectives and aligning your investment strategy with your overall financial goals. Tax efficiency is a powerful complement to sound investment principles.


Optimizing Your Investment Tax Strategy

Understanding the complexities of tax treatment and structuring your investments for optimal after-tax returns requires expert guidance. At Northland Wealth Management, we work closely with affluent families and their advisors to create strategies tailored to their unique needs.


Whether you’re seeking to protect generational wealth, manage a family enterprise, or optimize portfolio performance, our goal is to ensure tax efficiency while maintaining alignment with your overarching financial objectives.


If you’re ready to learn more about how to optimize your portfolio and enhance after-tax returns, contact us today for a personalized consultation. Together, we’ll craft a strategy to help you achieve your financial aspirations while keeping more of what you earn.

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