Why Is Income Tax Important When Making Investment Decisions

by Tax Guy - Burlington Accountant on August 20, 2009 Print This Post Print This Post

When we talk investing, not all types of investments are equal: At least as far as the Income Tax Act is concerned. If you have investments outside of a tax-deferred account like an RRSP, be aware of how income tax erodes your investment returns.

Every time you receive dividends, interest or have capital gains, the taxman wants a cut. This reduces the amount you have available to re-invest in the stock market. And while there are strategies to defer income tax over time, such as using an RRSP or timing capital gains, income tax can never be completely avoided.

Interest, Dividends and Capital Gains

Interest received from debt instruments such as bonds, GICs and T-bills, are taxed just like regular income. There is no special treatment and no special tax credits. You simply add interest to your taxable income.

Dividends From Canadian Companies are payments made from a corporation to its shareholders. These payments are made from after-tax income. If you own shares in a Canadian public corporations there is a combination “gross-up” and “tax credit” designed to reduce the impact of tax already paid by the corporation.

Dividends From Foreign Corporations. Dividends received from foreign corporations are taxed just like interest. If a foreign withholding tax was withheld, you may claim the foreign tax credit.

Capital Gains are a special type of income. One-half of the gain is included in your income and taxed, but only when you sell the share. Thus, you have the opportunity to time when you will receive a capital gain.

Comparing Interest, Dividends and Capital Gain

Interest, dividends and capital gains have different tax treatment. While we can generally say that dividends from Canadian corporations and capital gains are more tax efficient than interest income, the actual amount of tax varies depending on your province of residence and income level.

Let’s compare Ontario and Manitoba.

Ontario

Annual Income

Interest

Eligible Dividends

Capital Gains

$45,000

31.15%

6.94%

15.58%

$125,000

46.41%

23.06%

23.21%

From the above table you can see that in Ontario, dividends are generally lower than capital gains and capital gains are taxed lower than interest. However, in Manitoba, this relationship changes as annual income increases.

Manitoba

Annual Income

Interest

Eligible Dividends

Capital Gains

$45,000

34.75%

6.94%

17.38%

$125,000

46.40%

23.83%

23.20%

Final Thoughts

It is important to consider income taxes when making investment decisions. As a general rule, interest generating investments are less tax efficient than interest and dividends and are best held in tax-deferred accounts such as RRSPs. Similarly, dividend and capital gains generating securities should generally be held outside of registered accounts.

About The Tax Guy...

Dean Paley CGA CFP is a Burlington accountant and financial planner who services individuals and business owners locally, nationally and internationally. Dean has appeared in the National Post, Toronto Star and Metro News.

To find out more, visit Dean's website Dean Paley CGA CFP or connect via Twitter @DeanPaleyCGACFP.

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