Monday, January 21, 2008

Investing and Taxes

Until this year, I never really considered myself an investor. Even though I have been making bi-weekly contributions to an RRSP for the past seven years, I've only recently begun to think about how my investments are allocated, both across asset classes and across markets.

There are a couple of reasons for this:
  • The Employee Savings Plan under which I make my regular contributions has a two-year vesting period. This means that, until you've been enrolled in the plan for two years, you have to leave your shares untouched, or else you forfeit the employer's matching contributions. As a result, I spent my first two years deliberately ignoring my ESP account, and this habit survived beyond the end of my vesting period.

  • I'm in debt. This has automatically put me in the mindset of trying to reduce my debts, rather than grow my assets.
Because of my limited exposure to investing, I haven't had to deal with tax considerations around my investments, beyond declaring RRSP deductions on my tax return.

As I get my financial machine running more smoothly, I'm starting to see the light at the end of the tunnel, and am beginning to imagine myself having investments outside my RRSP. As a result, I need to wrap my head around the tax concerns faced by investors.

There are several ways to derive income from investments:
  • Interest income from bonds, savings accounts, etc.

  • Dividends paid to shareholders

  • Capital gains from the sale of investments (stocks, rental property, etc.)
These three types of investment income are treated very differently from a tax point of view, and I thought I'd go into the details.

Interest Income

The first type of income has the simplest, but least favourable, tax treatment. Essentially, every dollar of interest that you earn is treated as regular income, and added directly to your taxable income for the year. This means that, if you have a marginal tax rate of 35%, and you earn $100 in interest, you will pay $35 in tax.

In Canada, interest paid on a mortgage for your primary residence is not tax-deductible. In general, interest paid on loans is only tax-deductible if the loan is used to buy investments. There is also a technique, known as the Smith Manoeuvre, which can convert your primary mortgage interest to tax-deductible status through leveraged investing.

Dividend Income

Dividends paid by Canadian corporations have a favourable tax treatment, although the formula for calculating dividend tax is quite convoluted.

Dividend income is "grossed up" by 45%, so that a $100 dividend adds $145 to your taxable income. If your marginal tax rate is 35%, then you pay $50.75 (35% of $145) on every $100 in dividend income. The flip-side, however, is the dividend tax credit. This is made up of a 27.5% credit at the federal level, as well as a provincial credit ranging from 8-18%. The Ontario dividend tax credit for 2008 is 10.15%, so the credit for a $100 dividend would come to $37.65. This means that the net tax on dividend income for our Ontario taxpayer at 35% would be $13.10. In low-income tax brackets, this net dividend tax can actually be negative, which can offset other taxes owed.

Capital Gains

A capital gain results from selling an investment from more than you initially paid for it. 50% of capital gains are added to your taxable income, so if your marginal rate is 35%, then you will pay $17.50 in taxes on every $100 in capital gains.

The nice thing about capital gains is that, with certain restrictions, they can be offset by capital losses (resulting from selling investments at a loss). So if our 35% taxpayer had a $200 capital gain and a $100 in capital loss, they would pay $17.50 on the $100 net capital gain.

Note that, just as mortgage interest on your primary residence is not tax-deductible, the sale of your primary residence does not result in a capital gain (or loss).

Diversified Income

Just as it's recommended to hold diverse investments to control risk, it's recommended to hold your income-generating investments in the most tax-efficient vehicle. Of the three types of income, interest is the least favourable, as seen below for an Ontario taxpayer with a 35% marginal rate:
  • Interest: $35 tax per $100 income

  • Dividends: $13.10 tax per $100 income

  • Capital Gains: $17.50 tax per $100 income
For this reason, interest-generating investments should only (or at least primarily) be held in a tax-sheltered account like an RSP. Since income from an RSP at retirement is already fully taxed at the marginal rate, interest income is no less favourable than dividends or capital gains in this kind of account. In a taxable account, however, dividends are the most tax-efficient type of income, followed by capital gains, so a taxable account is an ideal place for dividend-paying stocks.

7 comments:

Traciatim said...

Why get in to investing if your debt isn't paid? Wouldn't it be much better to get rid of any of the debt first and only do things that you get bonuses (IE, Like a company match RRSP)?

Loonies And Sense said...

I agree that getting rid of debt is the priority (I said this in the post). However, once the debt is gone, it would be nice to know a bit about investing before diving in head first. In the interim, all I'm doing is putting enough into my RRSP to get the full company match.

adam said...

I'm a bit confused... I'm an Ontario resident in the highest tax bracket. If I want to invest in dividend paying equities, should I hold them in an RRSP account or non-registered? What's the best place to hold them?

Great blog !!!

adam said...

I'm a bit confused... I'm an Ontario resident in the highest tax bracket. If I want to invest in dividend paying equities, should I hold them in an RRSP account or non-registered? What's the best place to hold them?

Great blog !!!

Loonies And Sense said...

Adam,

The decision on whether to invest in registered or non-registered accounts depends on more than just taxation. What are your investing goals? Are you setting money away for retirement, or are you likely to need the funds within the next 5-10 years?

The favourable tax treatment of dividend income only happens in non-registered accounts; dividend income in an RRSP is treated exactly like interest income.

Come 2009, however, you'll be able to use the TFSA to shelter a good chunk of your investment income. The Canadian blogs in my blogroll have lots of good theorizing on how this new account affects the investing landscape in Canada.

adam said...

Thanks for the reply - yes, this is for retirement savings with no chance of me pulling out the funds for 20 years or so.

I guess I have to do some calculations on what is more favourable... dividend income taxed lower or bulking up the RRSP and treating the div's as interest income.

I assume in the short term, it won't make that big of a deal as the dividends won't be that huge, but as my investments grow it could have big implications...

Loonies And Sense said...

Adam,

I share your confusion of "what do I do with my RRSP when I retire?" Lots has been written on this topic, but I'm still trying to wrap my head around it. I recommend Googling RRSP meltdown strategies.

To me, it seems the advantage to long-term dividend investing outside an RRSP is that it generates an ongoing, favourably taxed income stream that will continue into retirement. Provided that you also take advantage of the tax benefits of RRSP contributions, non-registered dividend investing can be part of a good overall investing strategy.