When investing outside of tax shelters such as RRSPs and TFSAs, it’s important to consider an investment’s after tax rate of return – the money that actually ends up in your pocket.
Interest income earned from investments such as bonds, GICs and T-Bills are generally taxed at your highest marginal tax rate, which is the rate applied to each additional dollar of income you earn.
Investments that generate capital gains or Canadian dividends are taxed more favorably than interest income. Whether you can accept the tradeoffs between the potentially greater volatility of investments that can give you capital gains and dividends vs. the relative stability of interest-generating investments is an important question you need to ask yourself.
Dividends earned from a Canadian corporation (this is an important detail: has to be Canadian) are taxed at a lower rate than interest income. This is because dividends are eligible for a dividend tax credit, which recognizes that the corporation has already paid tax on the money being distributed to you, the shareholder. Note again that dividends paid from foreign corporations are not eligible for this dividend tax credit.
Capital gains result when you sell an investment for more than you paid for it. You pay tax on only half of this gain. Importantly, you can reduce your capital gains by your capital losses, so you pay tax on 50% of your net capital gains at your marginal tax rate.
Let’s assume you’re at the top marginal tax rate and you earn $100 from three different sources of income: Interest, Capital Gains and Canadian Dividends. You’d keep about $54 of your interest, $77 of your capital gains, and $75 of your dividends.
Tax efficient income strategies are an important part of your overall investment plan, regardless of your stage – we’d be delighted to take a look at your portfolio and help you identify areas where you could be more efficient, so feel free to call!