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TAXFlash News from IncomeTaxCanada.net
:: The impact of income tax on the investment returns
February 6, 2004 :: A local investment guru approaches you with three different investments to sell: investment A offers a return of 4.5% per annum; investment B’s annual return is 4.25% and the return on investment C is 4.0%. All returns are guaranteed and you pay income tax at the highest marginal tax rate. Which investment would you pick? Well that’s pretty simple – maximize your return and go for investment A, right? Perhaps, but the correct answer cannot be determined without considering the impact of income tax on the investment returns. For example, assume that the return on investment A is in the form of interest, investment B yields dividend income and investment C produces capital gains. Let’s also assume that you’re a resident of British Columbia at the end of the calendar year. Interest income receives no special income tax treatment so you can expect to pay income tax on your 4.5% return at a rate of 43.7%. This will leave investment A with an after-tax return of approximately 2.5%. Obviously income tax plays an important role in making investment decisions. Not only are different sources of income (interest, dividends and capital gains) taxed differently but such differences change depending on the taxpayer’s marginal tax bracket. Wise investors know this and so should you.
Dividend Investment Yields in Canada...right in the middle.Dividend income earned in Canada is eligible for a dividend tax credit that works to reduce the impact of income tax on the recipient. Dividends are paid out of after-tax corporate earnings so they come with a special tax-reducing credit to recognize the corporate tax that has already been paid on the earnings prior to distribution as a dividend. In B.C. the top personal income tax rate applicable to dividends is 31.6%. Applying this rate to investment B’s 4.25% return, we find that investment B yields an after-tax return of about 2.9%. Where capital gains are concerned, only one-half of the actual capital gain is subject to income tax. What this means in simple terms is that capital gains are taxed at one-half the rate at which interest income is taxed. In other words, if the top tax rate applied to interest income is 43.7%, then the top tax rate applicable to capital gains is one-half of this amount or 21.85%. This being the case, investment C in our example will yield an after-tax return of around 3.1%. Looking again at our investment returns after considering the impact of income tax we find that investment A offers an after-tax return of 2.5% per annum; investment B’s annual after-tax return is 2.9% and the after-tax return on investment C is 3.1%. Now which investment would you choose? Notice how the highest pre-tax yielding investment (investment A) has the lowest after-tax return and the lowest pre-tax yield investment (investment C) offers the highest after-tax return. This complete reversal is simply a function of the type of investment income and the effect of income tax on each income source. At the highest personal tax rate, interest income gets clobbered while capital gains get treated with kid gloves in comparison. Dividend income sits comfortably in the middle. At the lowest personal rate of tax interest income continues to get hammered, relatively speaking, however, at this level dividend income rules the roost with capital gains taking the middle ground.
Free Tax Advice Article Submitted to Income Tax Canada.net exclusively by Jim Maroney Official details about this and other topics on income taxes can be found in English & Francais at www.ccra-adrc.gc.ca Income tax information offered by www.IncomeTaxCanada.net is done so without endorsement by Canada Revenue Agency (CRA) - l'Agence du Revenu du Canada (ARC) (formerly Canada Customs and Revenue Agency - l'Agence des Douanes et du Revenu du Canada CCRA-ADRC and formerly Revenue Canada – Revenu du Canada) or any Canadian government agency. The free advice is of a general nature for Canadian taxpayers seeking legal ways to reduce their personal and small business income taxes payable to the federal and provincial (or territorial) governments in Alberta, British Columbia, Manitoba, New Brunswick Newfoundland-Labrador, Northwest Territories, Nova Scotia, Nunavut, Ontario, Prince Edward Island, Quebec, Saskatchewan or Yukon. Specific taxation situations vary from taxpayer to taxpayer, province to province, territory to territory. The free tax advice here is only a general guide. Canadians should always seek individual guidance on accounting rules and tax laws from knowledgeable accountants and lawyers. To prepare your income tax return online and NetFile your Canadian income taxes electronically in English or Francais, please visit www.ufile.ca or www.impotexpert.ca websites. Additional information on financial products and services for Canadians can be found at www.CanadianCreditCenter.com. |
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Jim Maroney