Together with the end of April, the tax deadline is creeping closer. We still have lots of tax planning tips for you. Today we’ll look at investment income.
The normal types of investment income you earn are interest, dividends and capital gains. Each of these is taxed differently.
Interest is taxed as normal income at whatever your marginal tax rate is. In Ontario, this means 46.41% in the highest bracket. Capital gains are only one-half taxable, so the effective rate on this type of income is only 23.21% at the highest bracket.
Dividends are taxed somewhat uniquely because of their nature. They are a distribution of after-tax profit to the shareholders of a corporation. So dividends are taxed to reflect the fact the corporation paying the dividend has already paid tax on profits. If you’ve been paid dividends, the amount included in your income is “grossed-up” to notionally reflect the total amount of pre-tax income the corporation has earned. You would then receive a credit to offset the tax the corporation has already paid.
There are two types of taxable dividends. The first are called “eligible.” These dividends are paid from public corporations, or from private Canadian-controlled corporations whose income was taxed at the highest corporate rate. “Non-eligible” dividends are from Canadian-controlled private corporations that have paid tax on their income at the small business rate.
The tax rate on eligible dividends in the highest bracket is 28.19% for 2011 while the tax rate for non-eligible dividends is 32.57%.
Now that you have a break down, let’s look at your tax planning opportunities. You can consider acquiring investments whose gain, when sold, would likely be taxed as a capital gain, such as publicly traded shares or real estate. There are a number of rules to determine whether a particular gain is a capital gain or regular income, but in most cases these types of investments are capital gains.
You can also acquire shares that pay dividends rather than investments that pay interest, your chartered accountant can help you with this. There are many large corporations who have issued preferred shares that pay a dividend, offering a better after-tax rate of return than many interest-earning investments, while also offering what can be considered a guaranteed yield.
If you’re in a situation where one spouse earns dividend income, but whose total income is very low, they may not be able to take full advantage of the dividend tax credit they’re allowed. The higher- income spouse can claim the dividend income earned and then can claim the full dividend tax credit.
If you acquire investments that pay interest, you must declare the interest earned annually. You can defer tax by acquiring an investment that matures after the end of the current calendar year, delaying the income inclusion for one year.
If you’re able to acquire investments outside of your RRSP, it may be possible for you to have interest deductibility on borrowed money. Interest is generally not deductible when the loan was taken out for a purpose other than to earn income subject to tax. Examples would be your home mortgage, credit cards or loans to buy RRSPs. But if you borrow money to buy shares that pay dividends or investments that pay interest, the interest you pay for these investments would be deductible.
With appropriate tax planning you can structure your affairs so the interest you pay on things like your home mortgage, for example, would be tax deductible. You can do this by using the money from the mortgage to buy your income-earning investments.
Another tax effective strategy is to acquire shares of mutual funds. These are pools of assets invested by professional managers. Annual income earned by these funds is taxed to you as it’s earned as dividend income or interest. But the growth in value of the funds is only taxed to you upon sale.
By organizing the types of investments you acquire and managing how they are required in the most effective and appropriate way, you can substantially reduce the taxes you pay and increase your net after-tax return on your investment.