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Your investments and taxes

When you're thinking about where to invest your hard-earned dollars, there are many things to consider, including your financial goals, investor profile, and risk tolerance. That said, it's also critical to understand how your investments are taxed outside of an RRSP or a RRIF. There are three main types of investment income — interest, dividends, and capital gains — and each is taxed differently, ultimately affecting the return on your investment.

Investments that earn interest — such as Guaranteed Investment Certificates (GICs), Savings Bonds, and Treasury Bills — are taxed at the highest rate. The interest you earn on these investments is taxed at the same rate as your employment income. As a result, although this type of investment offers reduced risk, it's also the least tax-effective. Here's an example. Suppose you've managed to save a substantial amount in GICs and they generate $1,000 in interest income. That amount is taxed at your marginal rate* — for instance, 40 per cent — leaving you with only $600 at the end of the day.

You receive Canadian dividends if you own stocks in Canadian corporations that pay dividends. Before distributing dividends, Canadian corporations pay tax on their profits. The dividend tax credit is provided to take this into account, and as a result Canadian dividends receive preferential tax treatment. Here's a simplified version of how the amount of tax payable is calculated. The value of the dividends you receive is first increased (or "grossed up") by 25 per cent. That means your $1,000 in dividends are actually represented as $1,250 of income on your tax return. The good news is that, when the dividend tax credit kicks in, you end up paying less tax and will retain close to $750, assuming a 40 per cent marginal tax

A capital gain is triggered when you sell an asset, like stocks, for more than you bought it. Capital gains are currently the most tax-effective form of investment income. That's because currently only 50 per cent of the gain is actually subject to tax — at your regular marginal rate. So, let's say you buy shares for $1,000, and sell them for $2,000. Your gain is $1,000, but you are only taxed on half of that, or $500. If you're in the 40 per cent tax bracket, that means you only pay $200 tax on your $1,000 gain, leaving $800 in your pocket.

Understanding how different types of investments are taxed will help you build a tax-efficient portfolio that will make the most of your investment dollars.

Of course, it's important to remember that everyone's situation is different. The information set out in this article is for informational purposes only and reflects the tax rules in effect on June 18, 2002. If you would like detailed tax advice, you should seek professional assistance from an accountant or other tax advisor. You might also want to visit the sites below.

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*The marginal tax rate is the rate of tax payable on each additional dollar of income earned.