Deciding where to put your investment dollars can be a complicated task. It depends on a number of factors, including your goals, your age and the risk you want to assume. And while many look for the highest rate of return, or yield, they think they can get, there are a couple of other factors to consider.
Chasing just high yield can carry risks — as witnessed by the number of investment bubbles that have burst over the past few years.
But another consideration is that different investments are taxed differently, with the result that some have more favourable tax treatment than others.
“When you buy investments, it is always important to consider the total return, not just the yield,” says Ed Rempel, a certified financial planner with Ed Rempel & Associates, part of Armstrong & Quaile Associates Inc.
Understanding the different tax treatments is important when considering investments outside a registered retirement savings plan (RRSP) or a tax-free savings account (TFSA). (Investments in an RRSP are tax-sheltered until withdrawn, while all income earned within and withdrawals from a TFSA are generally tax-free.)
The examples below are from Ontario; tax rates vary from province to province.
There are three main kinds of investment income:
1. Interest income
This comes from investments such as high-interest savings accounts or guaranteed investment certificates. Of the three kinds of investment income, it is taxed at the highest rate. Let’s say your total income is $50,000 — that puts you in the 31.15% tax bracket. If you earn $10,000 in interest income you will end up keeping $6,885 of it after paying the taxes.
2. Dividend income
Dividends are basically profits you receive from your stock, or share, of ownership in a company or through an equity mutual fund. As a Canadian taxpayer you can claim a “dividend tax credit” that will lower the amount of tax paid on eligible dividends from Canadian companies. Canadian dividends are taxed at a lower rate than interest income. So, again, let’s say you fall into the 31.15% tax bracket, and you earned $10,000 in dividend income. You would end up keeping $8,657 of that after taxes. (Those with income below $40,000 are currently able to keep all of their $10,000 dividend income and receive a bonus of 1.89%.)
3. Capital gains (or losses):
This is the difference between what you originally paid for an asset, such as a stock or property, and what you sold it for, calculated at the time of sale. It doesn’t apply to your primary residence, but can apply to a second home such as a cottage. As an example, someone in the 31.15% tax bracket who earned $10,000 in capital gains would get to keep $8,442 of that once all the taxes were paid.
And of course, the rules can change. The federal government recently proposed doing away with a tax-saving technique used frequently in fixed-income investments held outside RRSPs and TFSAs. Essentially, the practice currently allows the fixed income in a bond mutual fund to be treated as a capital gain instead of interest, says Rempel.
“The issue is that investors have continued to have an insatiable thirst for investments with a bit more yield, which has led investment companies to use this technique in more and more products. Too much tax is being lost now, so the announcement in the federal budget is not surprising,” says Rempel. “In this case, investors will not experience a big loss, but there may be higher taxes on these investments going forward.”
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