Fewer taxes, please!

Your decision to invest in a certain stock, asset class, or region should be based on your goals, how long you plan to invest, your risk tolerance and a host of other factors.

As a rule of thumb, tax minimization is part of any sound investment strategy, but it shouldn’t eclipse the other reasons to invest.

Your decision to invest in a certain stock, asset class, or region should be based on your goals, how long you plan to invest, your risk tolerance and a host of other factors.

Before we start, I would like to explain one concept that will be useful for the remainder of this article which is the difference between “Average” and “Marginal” tax rates. Your average tax rate (also referred to effective tax rate) is the percentage calculated when the total tax paid is divided by your taxable income. Your marginal tax rate is generally the percentage of tax paid on the next dollar of taxable income. There is a difference between the two rates because Canada has a system of progressive tax rates.

When held outside a registered investment account, different types of investment income receive different tax treatment, so don’t be blinded by an investment’s pre-tax return. Instead, look beyond to the after-tax return potential, taking into consideration your income level and marginal tax rate, as well as any other considerations that might apply to your situation and affect the eventual return.

In most cases, you will retain more after-tax income from capital gains and dividends from Canadian companies than from interest income and foreign dividends.

Interest income: This interest income is fully taxable at your marginal tax rate, like salary.

Canadian source dividend income: Dividends received from Canadian corporations are effectively taxed at a lower rate than interest income due to the dividend tax credit that is applied to the federal and provincial tax payable. This tax credit is meant to recognize that the Canadian corporation paying the dividend has already paid tax on its earnings, which are now distributed to its investors.

Foreign income: All foreign income is fully taxable at your applicable marginal rate. Dividends from foreign corporations do not receive the same dividend tax credit. Like interest, they are taxed at a higher rate than those of Canadian corporations.

Capital gains: You may realize capital gains, or losses, when you sell an investment. Half of a capital gain is taxable at your marginal tax rate and half of a capital loss can be used to reduce taxable capital gains. It is the least-taxed source of investment income at higher tax brackets.

Return of capital: You may receive a non-taxable payment called a “return of capital” from an investment. These return of capital distributions reduce the adjusted cost base (ACB) of your investment for income tax purposes, and the reduced ACB results in a larger capital gain (or smaller capital loss) when you eventually dispose of the investment. Simply think of these distributions as tax-deferred income.

Here are a few tips to minimize taxes:

  • Consider income-splitting strategies that can transfer the tax-reporting obligation for investment income from higher- to lower- income family members, reducing your family’s overall taxes
  • Hold a greater proportion of your Canadian dividend paying stocks outside of your registered accounts. Likewise, interest bearing and foreign investments should be maximized inside of your registered accounts whenever possible
  • Before the end of the calendar year, think about selling certain investments to recognize capital losses caused by temporary market fluctuations - to reduce taxable capital gains realized on other investments during the year

Keep those simple rules in mind and speak with a qualified advisor about your unique situation to make sure you are optimizing your tax bill at the end of the year.

Remember, the dollar that matters is the one that stays in your pocket!

Mathieu's new column, Your Financial Corner, will appear in each edition of Chamber Vision magazine, published by The Greater Moncton Chamber of Commerce.

About the Author

Mathieu LeBlanc, CPA, CA, CIM

Associate Portfolio Manager, The Cormier Group of RBC Dominion Securities
Mathieu LeBlanc is a Chartered Professional Accountant and Associate Portfolio Manager with The Cormier Group of RBC Dominion Securities.