Step 7: Tax strategies for investors
Many Canadians take great care analyzing stocks, mutual funds and other investments so they can squeeze out every last penny of return. Savvy investors also spend time comparing brokerage fees and administration costs so they can select the most cost-effective investment services. However, not all investors are as thorough in determining the effect that income tax will have on their profits.
Since interest income, capital gains and dividends are each taxed differently, some investment strategies carry obvious tax advantages.
Interest income
Interest income takes a direct tax hit. It is added to your taxable income for the year and taxed at your marginal rate ? that is, the top rate you pay based on your taxable income. The interest income on compound investments, such as Canada Savings Bonds or long-term guaranteed investment certificates must usually be reported annually.
Dividends
Dividends from foreign corporations get the same tax treatment as interest. But dividends paid by Canadian companies get a break, since the Canada Revenue Agency (CRA) already collected tax on the corporate profits used to pay dividends. Applying the dividend tax credit results in a lower effective tax rate than for other types of income. The effective tax rate is the total tax you pay expressed as a percentage of your taxable income.
Capital gains
Capital gains are not taxed as heavily as interest income, but no longer carry the lifetime exemptions that favoured them years ago. A capital gain is profit on the sale or disposition of a capital asset, like a stock, after the cost of buying and selling is deducted.
For dispositions after Oct. 17, 2000, 50% of the capital gain (adjusted for costs) is added to your taxable income for that year and taxed at your marginal rate. Professional tax advice may be necessary to accurately interpret the capital gains implications of your investment strategies.
Capital losses
What if you lose money? Capital losses can only be deducted against capital gains, but unused losses may be carried back three years and forward indefinitely to be applied against other taxable capital gains.
Canadian securities
Investing in Canadian securities, which includes putting money into shares, bonds, debentures and some mortgages, does not automatically qualify you for the capital gains provision, so check with your financial adviser or CRA to be sure 50% of your profit will be tax-exempt and 50% of your losses may be deducted.
Expenses
Tax rules must be applied carefully to determine which selling expenses and costs, including brokerage commissions, may be deducted from profits to establish capital gain. The tax costs of a company's shares that were purchased at different prices are pooled for tax purposes. Mutual funds carry complications of their own. Check out the details with CRA or your financial adviser before you spend.
Equivalent after-tax yields
Ask your investment adviser to help you compare after-tax yields when selecting investments. Returns of interest, dividends and capital gains receive different tax treatments.
Capital gains, which are taxed only when realized, offer the most attractive after-tax yields, since only 50% of the net gain is taxed at your marginal rate. When comparing returns on interest-bearing and dividend-yielding investments, remember that the dividend tax credit may lead to a better after-tax return even if the dividend rate is lower than the interest rate.
While yields are a significant factor, do not forget to take risk, growth potential and liquidity into account when selecting investments.
RRSPs
Registered Retirement Savings Plans offer a tax-sheltered environment for investing. Inside an RRSP, interest income is tax-free, capital gains are sheltered from tax and tax-free dividend income can be reinvested to buy more shares.
You may, however, decide to do your high-risk investing outside your RRSP. A loss in your RRSP means permanently lost contribution room.
This could cost you in three ways: loss of your investment capital, loss of years of tax-free compounding and loss of the tax advantage of deducting capital loss from capital gains. Funds withdrawn from an RRSP are treated like interest income and added to your taxable income for that year.
In 2001, restrictions enforcing Canadian content dropped to a maximum of 70% of the RRSP portfolio. A penalty will be charged if foreign holdings exceed 30% of the investments in a RRSP.
Remember, it's what you keep that counts. Have your financial adviser help you weigh the tax implications of your investment strategies before you buy.