There are different kinds of investment income—and different tax rules for each. While designing an investment strategy outside a registered plan, you should take into consideration the kind of income you’ll earn.
Investment income breaks down into four basic categories:
Dividends are basically a payout of a company’s profits to its shareholders. Dividends paid by Canadian companies are eligible for the Dividend Tax Credit and receive preferential tax treatment.
With mutual funds, Canadian dividends earned by the fund are distributed to the fund’s unit holders and they enjoy the same tax advantages as dividends paid directly to the company’s shareholders.
Anytime you sell a capital asset whose price has increased from its average adjusted cost basis per unit, you generate a capital gain. Capital assets include things such as stocks, real estate and mutual funds.
If you own equity mutual funds, you may find that they generate capital gains every year, even if you don’t sell your units. Activity within the fund may require that a capital gains distribution be made.
Regardless of how you earn it, a capital gain receives tax-favoured treatment, as only fifty per cent of the net annual gain are added to your income and taxed.
Interest income is simply added to your income and taxed at your marginal tax rate. Within your mutual fund portfolio, your fixed-income funds are most likely to pay interest.
Because there are no tax breaks on interest income, you may want to minimize the interest-earning investments you have outside your tax-sheltered registered plan.
As you approach retirement, there are other investment options that can help you generate a tax efficient cash flow.
Return of Capital:
A return of capital is not considered income since it is merely a return of your original investment. It is tax efficient because it allows you to receive a cash distribution without triggering a capital gain. While the return of capital portion reduces taxes payable on the distributions, it reduces your cost base which will result in increased capital gains on the eventual disposition of the units.
Your investment decisions should be based on your risk tolerance and financial goals, not income tax goals alone. But you can make sure you take the tax treatment of your investments into consideration and take advantage of that knowledge, for example, by holding interest-earning investments inside your registered plan.