When investing outside of the tax-sheltered environment of an RRSP or RRIF, it is important to consider an investment's after tax rate of return in conjunction with your risk tolerance and investment goals. To reduce the tax paid on your investment income, you should consider investments that generate capital gains or Canadian source dividends as they are taxed more favourable than interest income.
Interest income earned from investments such as T-Bills, bonds, and GICs are generally taxed at the highest marginal tax rate. The marginal tax rate is the rate applied to each additional dollar of income you earn.
Dividends earned from a Canadian Corporation are taxed at a lower rate than interest income. This is because dividends are eligible for a dividend tax credit, which recognizes that the corporation has already paid tax on the income that is being distributed to shareholders. This however only applies to dividends from a Canadian corporation. Dividends paid from a foreign corporation are not eligible for the dividend tax credit.
As of 2006 there are now two types of dividends, eligible and non-eligible dividends, and they are treated differently from a tax perspective.
- Eligible dividends include those received from a public Canadian corporation and certain private, resident corporations that must pay Canadian tax at the general corporation rate. As a result, they have a federal tax credit of 18.97% and are grossed up by 145%.
- Non-eligible dividends include those received from Canadian-controlled private corporations not subject to the general corporate tax rate. They have federal tax credit of 13.33% and are grossed up by 125%. Note: Not all provinces and territories have a two-tier dividend structure.
The change was introduced in order to provide a more balanced tax treatment betwen corporations and income trusts. Before 2006 income trusts were not taxed on any income allocated to the unit holder, whereas dividends paid by a Canadian corporation are paid out of after tax earnings. This had lead many business ventures to restructure as income trusts rather than corporations.
Capital gains result when you sell an asset for more than you paid for it. This gain is offset by any losses and can be further reduced by any expenses that are incurred by the purchase or sale of the asset. The result is your net capital gain, however only 50 percent of that net gain is taxable at the appropriate federal and provincial rates.
In addition to earning tax effective investment income to minimize your tax liability, it is also important to implement appropriate tax deferral strategies. The best and simplest strategy available is contributing the maximum amount to your RRSP, which gives you an immediate tax deduction and tax sheltered growth as long as it remains in the plan. Other less commonly used strategies include:
Universal Life Insurance is a policy that combines life insurance coverage with a tax deferred investment component. Premiums paid are first used to insure life coverage and the balance accumulates in an investment account where it grows tax deferred.
Registered Educations Savings Plan (RESP) is a plan where contributions are used to fund a child or grandchild's post secondary education costs. The initial contributions are not tax deductible and any income earned within the plan is only taxable in the hands of the student at the time of withdrawal.
With knowledge and resources throughout the Scotiabank Group, your ScotiaMcLeod advisor can work with you and your professional tax advisor to recommend and implement a tax-effective investment strategy that is right for you.
