How distributions impact your after-tax dollars when you invest in non-registered accounts
Author: Sound Choices
April 4, 2018
The content in the below article is meant for Canadian investors only.
Many investors believe receiving distributions from their investment (e.g., ETF, mutual fund) represent an increase in value. However, these distributions come in many forms – dividends, return of capital, interest or even capital gains. From a tax perspective, they all are treated differently, which may have an impact on your long-term goals.
For example, here are four different sources of distributions, each paying $1,000. However, they all have very different tax implications, which can affect the after-tax value of a non-registered portfolio. (All assume a hypothetical 40% marginal tax rate.)
Let’s look at that in more detail.
1. Interest income
- GICs, bonds, treasury bills
- 100% taxable
- After-tax value: $600 ($1,000 – $400)
Keep in Mind
- With the current low interest rates, return amounts are also relatively low
- Because interest is included in your reported income, it may impact income-based programs1
2. Dividend income
- Corporations – dividends are distributions from a company’s earning to its shareholders
- Tax-preferred if it’s a Canadian corporation
- Company has already paid taxes so the Canadian tax system takes this into account by:
- ‘Grossing up’ the dividend amount on the individual’s tax return
- Offsetting taxes payable with a dividend tax credit
- After-tax value: $793 ($1,000 – $207).
- Grossing up: $1,000 x 138% = $1,380
- Taxes applied: 40% × $1,380 = $552
- Provincial (Ontario) tax credit: 10% (including surtax) × $1,380 = $138
- Federal tax credit: 15.02% × $1,380 = $207
- Net taxes payable: $552 taxes – $345 tax credit = $207.
Keep in Mind
- While dividends aren’t guaranteed, they are a signal that the company’s fundamentals are healthy and that management may be optimistic about the future
- Because the gross-up artificially increases net income, it can impact:
- Refundable or non-refundable tax credits2
- Programs that are dependent on net income on the tax return1
- Dividends from non-Canadian companies are fully taxable
3. Return of Capital (ROC)
- Your invested principal
If you withdraw a set amount from your investment – using a Systematic Withdrawal Plan (SWP) for example – and there isn’t enough interest and dividend income, the difference is made up of ROC.
- No tax due on the ROC, given it is the capital you invested
- After-tax value: $1,000
Keep in Mind
- ROC, however, reduces the adjusted cost base of the investment, which generally results in a larger capital gain when the investment is sold, hence taxes are effectively deferred.
- Situations where a ROC strategy, using a SWP, are most advantageous:
- When you need cash flow, but not taxable income (reducing your exposure to clawback zones)
- When market cycles are volatile
4. Capital Gains
- Selling an investment at a price higher than what you paid for it.
- The difference is your ‘capital gain’
- Taxable at 50%
- After-tax value: $800 ($1,000 – $200)
- Taxable amount: $1,000 ÷ 2 = $500
- Taxes payable: $500 × 40% = $200
Keep in Mind
- You can also realize a capital loss, if your sale results in receiving less money than you originally invested. Capital losses can offset capital gains from a tax perspective.
It’s important to determine where to receive your cash flow before you and your advisor decide what type of investment is right for you.
1 Financial transactions that are dependent on the size of net income on the tax return include Guaranteed Income Supplements, Provincial per diem rates for nursing homes, certain provincial medical / prescription plans.
2 Net income affects refundable or non-refundable tax credits such as the Canada Child Tax Benefit, the GST credit, provincial refundable tax credits, Old Age Security clawbacks, charitable donations, age amount, spousal amount, medical expenses, amounts for other dependents.
Interest: fully taxable with a hypothetical 40% marginal tax rate; $1,000 in interest will return $600 after tax.
Dividends: (assuming the individual is taxed in Ontario and the dividend is eligible) a $1,000 dividend gets grossed up by 38% in 2018 to $1,380. Then the assumed 40% marginal tax is applied to result in taxes of $552 (40% × $1,380). The $552 in taxes are reduced by the provincial and federal tax credit of 10% (including surtax) and 15.02%, respectively (10% × $1,380 + 15.02% × $1,380), which creates a tax credit of $345. This amount is subtracted by the taxes otherwise payable to give $207 tax payable ($552 – $345). Therefore, a $1,000 Canadian dividend would provide an after-tax value of $793.
Return of Capital: The returned capital amount is not taxable in the year received, but reduces the adjusted cost base of the investment, which generally results in a larger capital gain when the investment is sold, hence taxes are effectively deferred.
Capital Gains: Have preferential tax treatment where only 50% of the gain is taxable. Only 50% of a $1,000 capital gain is taxable, which means that only $500 would be subject to the 40% marginal tax. $500 × 40% = $200 taxes payable, therefore a $1,000 capital gain would result in an $800 after-tax return.
The contents of this Web site are provided for informational and educational purposes, and are not intended to provide specific individual advice including, without limitation, investment, financial, legal, accounting or tax. Please consult with your own professional advisor on your particular circumstances.
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