Steve McGuinness
Special to Niagara Now/The Lake Report
In a recent column (“Reducing tax on your savings and investments,” July 31), we discussed the importance of using a registered retirement savings plan, or RRSP, and a tax-free savings account contributions to maximize after-tax investment returns.
This week, we review the tax implications of holding deposits or securities outside of these tax plans.
Interest earned on deposits and bonds is fully taxed, like ordinary income, at marginal tax rates. This makes them the least tax-advantaged investment income sources.
The taxation of shares issued by listed Canadian corporations differs from interest. The implications of holding foreign property (including shares) and private issues will be discussed in future columns.
A dividend is a distribution of a corporation’s after-tax income. So dividends paid to shareholders from earnings have previously been taxed on a corporate return as business income.
There is, however, a residual tax owed by the shareholder when dividends are paid.
The tax policy goal is to match the total tax paid on distributed corporate profits to what would otherwise be paid if the same business was operated by an individual outside a corporation.
Our tax-on-dividends rules initially include the dividends in the shareholders’ taxable income — at 138 per cent of the amount paid — and then allow an offsetting dividend tax credit to reduce the net tax amount owed.
Tax credits are more valuable than deductions because they directly reduce taxes whereas deductions just reduce taxable income before tax is calculated.
Since a tax credit reduces tax by a constant amount, ignoring the recipient’s tax bracket, it has a greater effective value to lower-income shareholders than to higher-rate taxpayers.
To illustrate by example: in Ontario, a shareholder earning between $57,375 and $93,132 would pay an effective 6.39 per cent tax rate on a dividend far below the 29.65 per cent they would pay on other income.
However, at the higher end of the rate card, an Ontario taxpayer earning over $253,414 would pay 47.47 per cent on dividends compared to a 53.53 per cent general tax rate.
So while both will pay lower tax on a dividend than on other income, the lower-income shareholder pays much less tax.
Alternatively, investors can also earn income on assets held within an investment trust. Real estate investment trusts, mutual funds, exchange-traded funds and resource properties are commonly organized as trusts.
Income produced by their investments is not taxed within the trust. Instead, the distributions from a trust flow out to beneficiaries annually and retain their underlying character.
So, for example, if a mutual fund trust holds shares, its unitholders as beneficiaries would be taxed exactly the same on the shares’ dividends as by holding the shares directly.
In addition to earning dividend income, investors may also realize capital gains when they sell — the difference between proceeds received on sale and the cost paid to originally buy the investment. We’ll discuss the tax implications of realizing capital gains in a future column.
By understanding how income on different investments gets taxed, you can enhance your after-tax yields by holding the more tax-advantaged investments outside of your RRSP and tax-free savings account.
In his Bay Street career, Steve McGuinness was a senior advisor to large financial institutions and is now retired in NOTL. Send your personal financial planning questions to him at smcgfinplan@gmail.com.
