Most people understand the value of investing for the future. Building wealth over time is a great way to achieve your financial goals and, ultimately, enjoy the retirement lifestyle you envision. However, not everyone knows how investment taxation works. Taxes can erode long-term wealth, and that’s why it’s good to seek tax efficiency in your portfolio.

Tax-efficiency issues don’t apply to registered accounts like RRSPs or RRIFs, since growth achieved in such accounts is tax deferred until you withdraw from it. For TFSAs, investment growth is never taxed because contributions are made with after-tax dollars. Non-registered investment accounts are taxable annually as you earn income, so that’s where it pays to be tax smart.

Let’s explore different types of investment income you may earn and how they’re taxed.

Interest

Any interest or other similar income earned from investments like GICs, Treasury bills and savings accounts are taxed at your highest marginal tax rate (similar to employment income). That makes interest the least tax-efficient income source. An investor may choose to put interest-bearing securities in a registered account since they can grow tax deferred until withdrawal, but check that this strategy works within the framework of your overall investment plan and specific financial circumstances. While tax is an important consideration, it’s typically not wise to let taxation issues alone drive your investment decisions.

Dividends

Stocks of eligible Canadian corporations may pass some of their earnings to investors in the form of dividends. Dividend income receives preferential tax treatment in non-registered accounts since they qualify for the federal dividend tax credit. Canada Revenue Agency (CRA) has devised a formula to claim the tax credit for dividends earned. We won’t run through the formula but you can learn about it here. Although the dividend tax credit only applies to non-registered accounts, don’t necessarily avoid holding dividend-earning stocks in registered accounts. Again, such decisions depend on your own situation.

Capital gains

When you sell a security like a stock or bond at a profit (i.e., a higher price than you paid), it may be subject to capital gains tax. Let’s say you bought 1,000 shares of a stock at $5.70 per share, and sold it for $6.50. Your capital gain (not including commission fees) is $800 (1,000 x $0.80). Fortunately, the CRA taxes 50% of capital gains, so you’ll only need to pay tax on half of your gain ($400) when filing your income tax return. As with dividend income, the tax benefit of capital gains applies to non-registered accounts, so that’s something to think about when determining where to hold this type of security.

Return of capital

A mutual fund may create cash flow by returning to unitholders some of the capital invested in the fund. Return of capital (ROC) is not taxable when distributed because it’s simply passing back a portion of each unitholder’s invested capital. Just bear in mind that ROC reduces your adjusted cost base (ACB), which is the price at which you’ll be deemed to have sold. As a simplified example, if you invested $10,000 and sold your fund holding at $12,000, it’s a $2,000 capital gain. However, if you received $750 in ROC over the course of investing in this fund, for tax purposes you’ll be deemed to have bought at $9,250 ($10,000 - $750 ROC), so your capital gain rises to $2,750. If you sell at a loss, then ROC reduces the amount of that capital loss. Holding ROC-distributing funds in a non-registered account allows you to benefit from this tax-efficient stream of cash.

A well-diversified portfolio that considers tax efficiency can help grow long-term wealth, so be mindful of which accounts you use for certain securities. Although this blog isn’t a comprehensive review of income taxation, it gives a sense of how different types of income may be taxed, helping to inform your investment decisions. A wealth advisor, such as an Alterna Advisor, can provide the personalized advice needed to invest tax efficiently.