It all depends on your personal situation and how you structure your investment portfolio.
A basic investment portfolio can generate three types of income:
- Interest income: Interest from savings accounts or money market funds, fixed income/bond interest paid to you are all considered interest income. For example, a five-year Government of Canada bond may pay you 3.75%, meaning for every $1,000 invested, you will receive $37.50 in interest each year. These interest income payments are taxed at your full marginal rate.
- Dividend income: If you buy shares in publicly traded companies, you may receive dividends, a company’s way of sharing its profits with its shareholders. You will receive a certain amount per share quarterly, semi-annually or annually. Dividends from Canadian controlled corporations have preferential tax treatment meaning you don't pay as much in taxes on these distributions as you would from employment or interest income.
- Capital gains or losses: If you sell your company shares you may generate a capital gain or loss. For example, if you bought shares in ABC Co. for $10 each and sold them for $20 each, you would have a $10-per-share gain. If, on the other hand, you bought at $20 a share and sold at $10, you would have a loss of $10 per share. That is a capital loss. Capital gains have preferential tax treatment. Only have of your gain is taxable at your marginal rate. For example, if you have a $10 capital gain, $5 of that gain will be taxed at your full marginal rate.
Each source of investment income is subject to a different tax treatment, but how and where you hold those investments will also affects your overall tax bill.
If you hold your investments in a registered account — such as a registered retirement savings plan (RRSP), a registered education savings plan (RESP) or a tax-free savings account (TFSA) — any investment growth inside your account will not be taxed.
The tax treatment for your contributions and withdrawals will be different for each account, though. With RRSPs, you get a tax deduction for your contribution. But when you withdraw money, your entire withdrawal will be taxed at your marginal tax rate.
With RESPs, you don’t get to deduct your plan contributions, so withdrawals of those contributions are not taxed. Withdrawals of any investment growth are taxed, however, but in the hands of the child who uses the money to pay for his or her post-secondary education. That person presumably is in a lower tax bracket than you, and can also use some of those education expenses to further reduce his or her tax bill.
TFSAs are the exception. TFSA contributions are not deductible, and withdrawals are not taxed. Any investment income and growth is entirely tax-free.
Investments in non-registered accounts
Interest income is 100% taxed. So, if you hold bonds in a non-registered account, that $37.50 in interest will be added to your income in the year it’s earned, and you will pay tax on it at your marginal rate.
Dividends from foreign corporations are taxed as ordinary income, just like interest. However, dividends from Canadian corporations receive preferential tax treatment.
The most favourable tax treatment goes to capital gains. In the year in which you sell your stock you are required to include only half of that gain in your income, which is then taxed at your marginal tax rate. To go back to our ABC Co. example: You sold the shares, for which you paid $10 a share, for $20 a share, making a $10 profit. Only 50% of that gain, or $5, is added to your income.
That’s one tax advantage for capital gains. Another is that they are under your control. You can decide when you want to sell the asset and take the gain. For example, you could take the gain in a year when you have an offsetting loss, or when your taxable income is lower because you were out of work. When you choose to take the gain becomes part of your tax strategy.
So, how could these tax differences affect your investment strategy?
They won’t affect your overall asset allocation strategy. You’ll still have the same percentage of your investments in bonds, dividend stocks and equities held to produce capital gains. But you won’t necessarily have identical asset allocations for each account. Instead, you’ll adjust the allocations for each account to take advantage of the varying tax treatment that each investment and account offers, while still maintaining the same overall asset allocation.
For example, your RRSP could own more of the investments that earn heavily taxed interest income, to protect that income from tax as all money coming out of a RRSP is taxed fully as income. However, your non-registered accounts could own more of your investments that produce dividends and capital gains, because those assets already offer some tax sheltering.
This is an extremely simplified picture. Anything to do with taxes and investing should be part of a larger plan that takes into account your income needs, your investment time horizon and when you want to withdraw your money. But understanding the tax treatment of the different sources of income is a great basis for a serious discussion with your investment advisor or your accountant.
at the Opheim Wealth Management Group for more information on how we help clients tax plan.