Tax Efficient Investing – The Basics

Hello all, and happy new year! Now that the holiday season has passed, most of us are back to work, and (in some cases), turning our attention to tax season. I typically start receiving tax-related questions from friends, colleagues, and clients in late January. Those discussions tend to continue, through to the April 30th tax filing deadline. Inspired by this seasonality in income tax interest, we here at T.E. Wealth have decided to author and post a series of tax commentaries. This posting (the first of what will likely be a monthly publication) will provide taxpayers with some basic information about the taxation of investment income. Specifically, I will discuss how the three major types of investment income (interest, dividends, and capital gains) are taxed. My aim is to lay down a foundation for understanding more complex tax planning strategies, which I will discuss in future postings. First and foremost, I should point out that in Canada, employment income attracts the highest rate(s) of income tax. At some point, I’m sure that all of us have been surprised with the amount of income tax that is withheld from our pay cheques, but nonetheless, such might be news to some of you. In addition to paying taxes on earned income, investors must also pay income tax on investment income. The applicable tax rates applied to investment income can be much more favourable than those applied to earned income. Not all forms of investment income are taxed in the same way. A good understanding of the three major types of investment income, and the application of tax on them, is important when structuring a tax-efficient portfolio.

Interest

Of the three main types of investment income, interest income is taxed in the most punitive manner. Interest income that we earn is added to our taxable income, and thus taxed at our marginal tax rate. In Canada, marginal tax rates are a function of an individual’s income level, and range from 0% to roughly 50% (in certain jurisdictions). As an example, if an individual in Canada’s top marginal tax bracket (50%) owns a Canada savings bond worth $10,000, and that bond pays interest at a rate of 1% annually, that individual will earn $100 of income each year, and pay $50 in income tax. Such a situation would leave an investor with $50 of ‘after-tax income’. Interest income is thus taxed at rates that almost equal the rates applied to earned income. The only real difference between the taxation of interest income and the taxation of employment income, is that interest income is not subject to CPP nor EI.

Dividends

Dividend income is taxed much more favorably than interest income. Technically speaking, when reported on our tax returns, dividends are subject to a complex gross-up and tax credit mechanism. I will spare you the details of that calculation. A simple way to understand how dividends are taxed (once received in an individual’s hands) is to consider that dividends are paid by corporations, to shareholders. The CRA aims to have both the corporation and the individual shareholder pay some level of income tax, such that in total, the complete amount of tax paid would approximate an individual’s income tax rate, had he or she earned the business’ income personally. For example, if the average individual tax rate in Canada is 40% (on earned income), the CRA would aim to have the corporation pay some fraction of that 40%, and the shareholder to pay the remaining fraction of that 40% on the earned income of the corporation. A simple breakdown could be to have the corporation pay 9%, and the individual pay the other 31%, for a total of 40%. To illustrate, assume an investor owns shares in a public Canadian company, and receives a $1,000 dividend. A taxpayer in the highest marginal tax bracket would pay approximately $310 of income tax on such a dividend. That is much more favorable than the amount of tax that would be payable on the same amount of interest income. The important thing to note here is that a dividend received leaves a shareholder with more after-tax money than an identical receipt of interest income. In Canada, the effective income tax rates on dividends range from 0% to approximately 31%.

Capital Gains

The last form of investment income I would like to discuss is capital gains. Capital gains arise when a capital asset is purchased at a given price, and sold at a higher price. A common example would be stock in a public corporation. Like dividend income, capital gains income is taxed favorably. Specifically, capital gains are taxed at ½ of an individual’s marginal tax rate. For example, if a taxpayer’s marginal tax rate is 40%, and they generate a $1000 capital gain in their investment portfolio, they would pay $200 in taxes (½ of the investor’s marginal tax rate). As I mentioned above, understanding the preferential tax treatment administered to dividend and capital gains income is important in planning a tax efficient portfolio. In my next commentary, I will discuss a common strategy – holding one’s preferentially taxed income outside of registered savings plans, and holding high-tax income within registered savings plans. Stay tuned!

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These articles are for general informational purposes only. Please obtain professional advice before taking any action based on this information. No endorsement or approval of any third parties or their advice, information, products or services should be implied by any references to third parties contained in any article. Trademarks cited in these articles are the respective properties of their owners.

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