When it comes to choosing investments, it makes sense to pay attention to your investment objectives, time horizon and risk tolerance. It is also important to compare the way different investments are taxed, because the amount of tax you pay can have an overall impact on your net profit from investments.

Investments grow tax-deferred within an RSP, which means they will not be taxed until withdrawn. But outside an RSP, investment income is not tax-deferred, but instead is generally paid as it is received, resulting in the potential for a higher tax bill.

Over the long term, having a tax-efficient portfolio can save you thousands of dollars. When it comes to non-registered investments, investors pay the most tax on interest and the least on capital gains. Dividends fall somewhere in between. Consider an example. You realize an income of $10,000 on an investment. The type of income that was generated will dictate how much tax you will have to pay and ultimately the amount of your after-tax return.

Tax on Interest

Tax on interest is calculated at your full marginal tax rate, which varies depending on your income and province. In some cases, you can expect to pay up to 50% tax on interest income if you are in the highest tax bracket.

Tax on Capital Gains

Tax on capital gains is also calculated based on marginal tax rates. The difference is that you are only taxed on 50% of your gains. Capital gains only need to be reported when they are realized. For example, a $10,000 investment in the ABC Equity mutual fund five years ago may be worth $20,000 today, representing a $10,000 unrealized capital gain on paper. The tax on these gains can be deferred as long as the investment is held. Once sold, a tax liability would be incurred on the difference between the book value and the price at which units were sold.

A second scenario when taxes are required to be paid occurs when the mutual fund itself generates any distributions by trading activity that is exercised by the fund manager. Whether or not a mutual fund pays any distributions is beyond the control of the unit holder—most funds pay an annual distribution (the amounts vary depending on the performance of the fund).

Of course, remember that capital gains are transient values that fluctuate with time until they are realized. This can be a double-edged sword. Many unlucky investors will remember all too painfully the bursting of the dot.com bubble in early 2000, when stratospheric technology stock prices promising bountiful capital gains for scores of investors abruptly gave way to capital losses when the bubble suddenly burst.

Tax on Dividends

A dividend is a distribution to shareholders of some portion of a corporation's earnings. Estimating the tax payable on dividends can seem complicated because companies pay tax on profits before distributing them to shareholders. Individual investors who receive dividends from a Canadian company are “grossed up” by 25% to represent the full value of the income the company is presumed to have made before tax. Then a federal dividend tax credit is applied equal to 13.33% of the inflated figure reported on the tax return, plus an additional provincial dividend tax credit. The tax credits are designed to reduce the double taxation of business income earned through a corporation when distributed to shareholders.

 What's the Best Investment?

The best investment ultimately depends on your needs (risk tolerance and time horizon). There is no question that capital gains-producing investments are the most tax-efficient, and are therefore probably your best choice if you are interested in equities.

As a general rule, if you don't need income, you should focus on capital gains. Funds focusing on capital gains generally have a higher return potential. Timing can make capital gains more appealing than dividends from a tax perspective. Whereas some investors will be able to defer capital gains for years, putting off their tax bill, that's not possible with dividends.

If you require regular income, you have a choice between dividend and interest income. The advantage of dividend funds is they offer a more tax-efficient cash flow, usually outperforming interest generating investments, and are reasonably stable since they invest primarily in blue chip stocks. Conversely, income-producing bonds and fixed-income mutual funds are more stable than dividend paying stocks. However, the cost of investing in bonds compared with dividend paying stocks comes in the form of higher taxes on interest income, as discussed earlier. As each investors' tolerance for risk will differ, you need to have a careful discussion with your advisor. Your specific risk tolerance and tax circumstances determines how much of each asset class to hold.

For investors who have enough money to maximize their RSP contributions each year and invest in non-registered funds, the most tax-efficient strategy is to hold their interest-and dividend-bearing investments within the RSP, and hold capital gains-producing investments in the non-registered account. Different investment options will suit different investors at different times in their lives. Understanding how investments are taxed can help you work with your advisor on the most tax-efficient investment strategy for you.

For more information regarding the content of this article, contact John Klotz. John is President of Northwood Mortgage Life. You can reach John at john.klotz@northwoodmortgage.com or call 416-969-8130 ext. 230