Just as taxes only let you keep a portion of your paycheque, they can also reduce the return on your investments. By focusing on — and understanding —your after-tax returns, you can better assess your future investment choices to help minimize tax on your portfolio returns.
How Investments are taxed
To determine your after-tax rate of return, you should first learn how your investments earn income and are taxed. Investments can earn income through interest, dividends and capital gains.
• Interest You can earn interest income through your savings accounts and/or your Guaranteed Investment Certificates (GICs). Your bank will make payments to you (interest) on the amount that you have lent them. Interest income is taxed at your current marginal tax rate.
You can also earn interest when you buy a debt instrument like a bond, either on its own or through a fund/exchange-traded fund (ETF). For example when it comes to taxes, an individual who earns $141,000 per year will pay 40.5% (Saskatchewan) of the interest they receive in taxes. A 4% interest payment has an after-tax rate of return of 2.38% = (interest x (1 - tax rate)).
• Dividends are a company’s after-tax earnings paid out to shareholders and are taxed less than interest. When you receive dividends from a Canadian company, the government gives you a tax credit to help offset the tax that the company already paid on those earnings.
After accounting for the tax credit, the tax rate is applied to the dividend income you’ve earned. For example, the tax rate applied to the dividend income of someone earning $141,000 per year is 19.98% (In Sask). This reduces the dividend income of 4% to 3.20% after-tax, which is much better than the 2.38% they were left with on the interest payment.
• Capital gains are the profit from selling an asset at a higher price than you paid for it. Your gain is divided in half which reduces the overall amount of tax you’ll pay. For example, in Saskatchewan, an investment which has increased in value by 4% results in an after-tax rate of return of 3.19%.
Another benefit of earning income through capital gains is that the gain is only taxed once the asset is sold. This allows you some control over when you’ll receive the proceeds from capital gains — as opposed to interest and dividends that tend to pay on a set schedule.
• Portfolio Returns are the financial returns a portfolio holder receives over a period of time (e.g., daily, quarterly or annually), and they can be calculated in a number of ways. For an investment portfolio return of 5% for example, which includes 1% of the interest earned on your savings account or GIC, plus 2% of income from dividends and 2% realized by your capital gains, your return is reduced to 3.79% after tax.
Strategies for minimizing tax in your portfolio
There are many ways to arrange your investment portfolio to increase your after-tax rate of return. A thorough discussion with your portfolio manager is a great way to learn about the mechanics of asset location. It may even help you to uncover unrealized opportunities to place higher taxed investments into low or tax deferred registrations.
"A thorough discussion with your portfolio manager is a great way to learn about the mechanics of asset location."
Together, you and your portfolio manager can examine all areas of your personal wealth including your investments in a TFSA, RRSP, Locked-in accounts, savings, cash and even corporate investments.
How CWB can support your financial goals
Our CWB Wealth Management Specialists have the knowledge and expertise to walk you through a variety of financial planning techniques suited to your unique financial goals. They will work in-step with your team of professional advisors to grow your portfolio.
We will consider all the factors that go into reviewing your tax situation and will work with you to determine your overall wealth management strategy.