In Canada, investor’s registered accounts allow for a tax advantage. This may be a tax-free or tax-deferred return on invested assets. However, when investing in cash accounts/non-registered accounts, tax on returns is paid on a yearly basis. This can impact an investor’s taxation incidence. It should be known how invested assets are earning a return to ensure tax efficiency for the investor. By better understanding potential tax incidence, the investor will understand of how to hold assets in different registered and non-registered accounts. The taxation will affect the ‘real rate of return’. The real rate of return is what the investor receives on a post-tax basis.
First, lets review the 3 main ways invested assets can earn returns. The main avenues are:
- Interest
- Dividends
- Capital gains
In this post I want to highlight the definitions of each avenue and their tax implications. I will then create an example of for each. For the following examples we will assume that our investors has $100,000 principal in a cash account. Furthermore, there is no tax deferral or exempt status for these fictional assets. The marginal tax rate our fictional investor is 40%.
1. Interest
Interest is the amount paid to the investor from the entity providing the product. Interest is usually defined by an interest rate, expressed as a percentage. This is the literal ‘interest’ the entity has in the investor’s asset. Products like Guaranteed Investment Certificates or Federal Bonds pay interest. In Canada, interest income from domestic sources is included as income and taxed as income. This can lead to a loss on the real return rate when held in a non-registered account.
For our example, we have a 10% Guaranteed Investment Certificate (GIC). We will use a 1-year term for this product. Then we will look at the tax implication of this GIC. First, the interest earned on our $100,000 investment is $10,000. This is the gross return of 10%. Since this investment is non-registered, the CRA is going to tax this at our investor’s marginal tax rate of 40%. This means our investor doesn’t get $10,000; our investor earns $6,000 after taxes or a real return of 6%. We lose $4,000 to taxes in this scenario.
Principal
$100,000
---------------------------
Return Rate @10%
=
$10,000
---------------------------
Taxable Income
=
$10,000
---------------------------
Taxes Due @40% MTR
$10,000 X 40%
=
$4,000
---------------------------
Interest earned Post-tax
$10,000 - $4,000
= $6,000
---------------------------
Real Rate of Return
$6,000/$100,000
= 6%
---------------------------
2. Dividends
In Canada, dividend income falls into 1 of 2 categories. Eligible and Non-eligible dividend income. Understanding the difference between these two categories will determine how the dividend income is taxed. Eligible dividends mean the corporation the paid a higher tax rate on the dividends; the investor will pay more taxes and will receive a higher tax credit.
Non-eligible dividends mean the corporation paid a lower tax rate on the dividends; the investor will pay less taxes and will receive a lower tax credit. Understanding what type of dividend is received should be reviewed with an advisor to understand what tax liability it will occur.
In this scenario we will assume the product is a dividend bearing stock, the $10,000 is received as dividend income. In our scenario, the dividends are eligible dividends. Below there is what is known as a gross up percentage. This calculation is used to determine the nominal value the dividend will be taxed at. This value is used to get the Provincial and Federal Dividend Tax Credits in Canada. Again, in this example, we will see our investor receive less than their quoted return. Once again, taxation negatively impacts the real return for our investor.
Principal
$100,000
---------------------------
Return Rate @ 10%
=
$10,000
---------------------------
Eligible Dividend Gross Up @38%
=
$13,800
---------------------------
Eligible Dividend Tax Credit Federal
$13,800 x 15.0198%
=
$2,073
---------------------------
Eligible Dividend Tax Credit Provincial
$13,800 x 8.12%
=
$1,121
---------------------------
Taxes Owing
$13,800 x 40%
$5,520
---------------------------
Taxes owed - Tax credits
=
$2,326
Interest earned Post-tax
$10,000 - $2,326
=
$7,674
---------------------------
Real Rate of Return
$7,674/ $100,000
= 7.76%
---------------------------
3. Capital Gain
A capital gain is defined as the increase in value of the asset relative to the beginning value over time. In simple language, the growth of the principal asset from time of investment to the present. If an investor purchases a stock for $10 and it grows to $15 over the course of a year, the capital gain is $5 on the stock. A capital gain can also accrue on hard assets like gold or real estate. In Canada, half of the capital gain is taxable at the investors marginal tax rate.
In this final example the $10,000 earned on the asset is a capital gain. As mentioned above, 50% of the gain is taxable. This means $5,000 of the capital gain is taxable. Using the 40% marginal tax rate there are taxes due of $2,000. Our real rate of return for this example is 8% as the investor gets to keep $8,000 of the gains post-tax.
Principal
$100,000
---------------------------
Capital Gain @10%
=
$10,000
---------------------------
Taxable Capital Gain @50%
=
$5,000
---------------------------
Taxes due at MTR of 40%
$5,000 x 40%
=
$2,000
---------------------------
Gain Post-tax
$10,000 - $2,000
=
$8,000
---------------------------
Real Rate of Return
$8,000/$100,000
8%
---------------------------
Summary:
Registered accounts often have a benefit of deferring potential tax. Non-registered accounts do not have this luxury. It is important to note how your assets are accruing returns. Depending on the classification, the taxable incidence will vary. Having a plan that utilizes registered and non-registered accounts can allow for the sheltering of gains in certain accounts. As we can see in the examples above, understanding how the assets realize return post-tax can have a great effect on the real return rate. Be aware of quoted returns on any product versus the amount an investor will receive on a post tax basis.
In comparing all 3 scenarios, we had different taxes owed by our investor. This negatively affected the real rate of return in each scenario. This is why it is important to understand how your product accumulates value. All 3 products had a nominal return of 10%, yet each one had a different real rate of return. Tax-efficiency plays a major role in financial planning. This is only one facet of tax-planning. There are other factors to be considered for the entirety tax planning. For comments and concerns related to your situation, please inquire directly.
Thank you,
Alexander
The information contained in this document has been prepared by Alexander Philipp a registered investment advisor attached to PEAK Securities Inc. The information has been obtained from sources considered reliable and relevant. The information in this document is general in nature and may not be complete in regards to your personal situation. This document does not constitute investment advice. The opinions expressed above do not necessarily reflect those of PEAK Securities Inc. Peak Securities is not liable for the content of this document.
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