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Interest is fully taxable as income, while Canadian dividends receive a favorable tax credit. Generally, capital gains are most efficient. Only half of capital gains are taxable, usually upon disposition. If you are an investor in individual stocks you have some control over when investments are bought and sold, and the timing of any realized capital gains. Don't Take Investment Returns at Face Value The situation is different for many mutual fund investors. Most money-managers are paid to maximize pre-tax returns – those you see published in mutual fund tables and newspaper advertisements. What these returns don't show, is how much actually goes into your pocket after tax. "Taxes can significantly erode your returns, meaning you actually make much less than those published numbers," warns Cestnick. "Most people don't realize the huge bite that taxes take out of their investment returns outside of a registered plan, and that different investments are taxed at different rates." Furthermore, you cannot simply conclude that a GIC paying 5% is better than a dividend rate of 4%. Dividends paid by Canadian companies are subject to a lower rate of tax than interest, and the equivalent after-tax return from dividends will end up being more than a GIC. Capital Gains are Most Tax-Efficient Capital gains are the lowest taxed form of investment income for most Canadian taxpayers. Firstly, only half of capital gains are taxable. Secondly, realized capital gains can be reduced by any realized losses. Thirdly, the realization of capital gains by selling your investments can often be deferred until a time of your choosing when your tax rate is low. "In managing its mutual funds, AIC's goal is to create long-term wealth for clients by concentrating on investments offering superior growth and tax minimization," Cestnick says. "Unrealized capital gains attract no taxation until the investment is sold. Therefore, AIC's aim is to own equities for the long term, with little buying or selling within portfolios to trigger taxes. " Consider the example of an individual who resided in Ontario in the year 2000. Jim invested $10,000 in a Canadian equity mutual fund, and during the year the fund distributed $300 of interest income and $500 of dividend income to Jim. This distribution of $800 was reinvested in the fund. In addition, the rising value of the stocks held in the fund resulted in unrealized capital gains of $700. At year end, Jim's holdings were worth $11,500, including
interest, dividends and capital gains. Jim had a total pre-tax return
of $1,500 or 15%. However, Jim's taxes are as follows:
The total tax paid by Jim is $301, which reduces his pre-tax return of $1,500 to $1,199 after tax. As a percentage of his original $10,000 investment, his real after tax return is actually only 11.9 per cent. Jim lost almost three percentage points of his total return to taxes. The example also illustrates why capital gains are the most efficient form of income, and why it's better to hold for the long term. If the stocks had been sold instead of held, capital gains would have been realized. Half of the $700 capital gain would have been taxable at 47.9%, resulting in an additional $168 of tax and a further reduction of Jim's return. Editor's note: It is true that capital gains are the most efficient form of income on an after tax basis and in a perfect world where capital investments always increased in value or at least never dropped by 40% or more in a year, they would be the logical alternative. However investors must often trade off the after tax efficiency of capital investments for the security of other investments such as GICs that provide less in their pocket after tax but provide the comfort of maintaining the investment principal. * * *
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