Life with Kids

However you invest, do it tax-smart

From sea to shining sea, taxes are as much a part of Canadian life as talking about the weather and the metric system. But wherever you invest, if you’re north of the 49th parallel, take heed of how your investments are taxed to get the greatest after-tax benefit – and keep more of those earnings in your pocket.

Start your tax-smart engines

As a rule of thumb, tax minimization is a part of any sound investment strategy, but 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.

Average versus marginal tax rates

Your average tax rate (also referred to as your “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 final dollar of taxable income. There is a difference between the two rates because Canada has a system of progressive tax rates. The average tax rate is always equal to or less than the marginal tax rate.

Not all investment income is created tax-equal

Different types of investment income receive different tax treatment, so don’t be blinded by an investment’s pre-tax rate of 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.

Once you’ve evaluated the investment’s after-tax returns, consider other factors, such as the investment’s risk level, the opportunity for capital appreciation, its liquidity, and so on.

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. As the chart on the following page illustrates, what you keep from $1,000 of interest, Canadian-source eligible dividends and capital gains varies relative to your tax bracket.

Class by class, how it all breaks down

Interest income

You may receive interest income at varying frequencies during the year, such as semi-annually or monthly. This interest income is taxable in the year it is received, and must be declared on your tax return.

If you do not actually receive the interest income during the year, you still must declare it as “accrued interest.” Accrued interest means the interest you earned in the year – even if it is not paid in the year. Investments that require the annual accrual of compound interest include compound Canada Savings Bonds, strip coupons and compound GICs.

If the term of an investment is not more than one year, such as a T-bill, the income should be reported in the year it is received.

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 dividends has already paid tax on its earnings, which are now being distributed to its investors.

Foreign income

Foreign income is fully taxable at your applicable marginal rate. Dividends from foreign corporations do not receive the same Dividend Tax Credit, and are taxed at a higher rate than those of Canadian corporations. You won’t be able to use the Dividend Tax Credit, which is only available for dividends from Canadian corporations.

Return of capital

You may sometimes receive a non-taxable payment called a “return of capital” from an investment such as a Real Estate Investment Trust (REIT), royalty income trust or mutual fund. These return of capital distributions reduce the adjusted cost base (ACB) of the 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. Think of return of capital distributions as tax-deferred income.

Capital gains and losses

You may realize capital gains, or losses, when you sell an investment. To determine how much of a gain will be taxed, you must first calculate the net capital gain by adding together your total capital gains and subtracting your total losses. A taxable capital gain is equal to half of the net capital gain, taxable at the marginal tax rate applicable in the current tax year.

Tax-loss selling and superficial losses

Tax-loss selling allows you to offset taxes on your capital gains, first within the current tax year, and if there are any remaining net capital losses, they can be carried back against capital gain for the previous three calendar years. If net losses still remain after this they can be carried forward to future years.

A superficial loss may take place if you sell any security and then acquire an identical security in the period starting 30 days before the disposition and ending 30 days after the disposition. The result of a superficial loss is that the capital loss will be denied, and that denied capital loss will be added to the ACB of the identical acquired investment. Essentially this means the capital loss cannot be immediately claimed for tax purposes. But if you delay your repurchase until after the 30-day period, superficial loss rules don’t apply – and you can claim your capital losses.

Be sure to consult with your professional tax advisor before taking any action on any tax strategy.