Investment income

Investment income
by Kevin Keith - 6, 2008

As the dust settles from a Roadrunner attempt at completing your tax return on time, some of you may be feeling the stings of paying additional tax on income earned from your nest egg. Unless you've been struck with a string of lotto luck, many of us find ourselves deciding how to invest a small savings in an investment that will make our dollars grow. When making these decisions, we don't always consider the tax implications that can be realized.

An optimal plan would be an investment that provides you with the highest after tax income. Following, is a list of various types of investment income, and the corresponding tax consequence that is realized.

Interest income
The most common form of investment income, and probably the one that you are most familiar with, interest income is fully taxable as earned. The tax notes on interest are similar to the notes on salary from employment. This means, even if the interest has not been received, it must be reported for tax purposes. With slumping interest rates a substantial portion of what little income is earned can end up in the hands of the government.

Capital gains
A capital gain is the net profit that is earned from the purchase and disposal of capital property. Capital property can take many forms. Shares, bonds, mutual funds, land, buildings and other assets can be considered capital property. The advantage of this investment is that income earned is only taxed at half of the profit that is earned. For example, if you purchase and asset for $100 and sell it for $160, you are only taxed on $30 as opposed to the full $60 profit.

Dividend income
Dividends are funds received from the after tax profits of a company. If a dividend is received from a Canadian corporation, tax rules are designed to consider tax has already been paid by the company. Therefore, you personally reap the benefits by receiving a dividend tax credit to partially offset dividends received. This credit represents the tax paid by the corporation and differs depending on the earnings of the company. We explained in an earlier article the different types of dividends that can now be received.

However, if your investment is in a foreign company, and dividends are paid, the results are not as profitable. These funds are treated the same as Canadian interest income, with the full amount being included in income for tax purposes.

Investment options
Once we understand the various types of income that exists, it is important to consider the different investments. Some specific types are listed below. By no means is this a complete list of the options out there. The below are some of the more common investments.

Mutual funds
Mutual funds are pools of money that are invested by professional managers. Mutual funds are essentially a flow through investment and income is earned by you on the funds income earned less any expenses. The fund earns various types of investment income, including interest, dividends, trust unit allocations and capital gains. These are treated, by you, the same as if you had directly been involved in the investments. Also, when you sell your share of the mutual fund, any resulting gain is considered a capital gain.

Exempt life insurance contacts
Life insurance contracts are a method to provide you with insurance coverage as well as income due to tax-sheltered growth. These types of policies allow you to make payments for insurance premiums as well as deposits into a tax-sheltered investment accounts simultaneously. Deposits are made with after-tax dollars, however the income that is earned by these deposits within the plan are free from tax until maturity or until the amounts are withdrawn. However, upon death, the entire amount can be received tax-free as a death benefit. If you plan to access funds from the policy during your lifetime, there will be tax consequences to consider.

New tax-free savings account
As per the recent federal budget, there is now a Tax-Free Savings Account (TFSA). Income earned on the funds deposited into this account is tax exempt. As much as $5,000 per year can be deposited by each individual, and funds can be deposited in investments similar to an RRSP. Therefore, couples have the opportunity to invest as much as $10,000 per year. Funds can be withdrawn at any point, with no tax consequence. Also, the contribution room grows by $5,000 as each year passes, therefore allowing you to increase your tax free earnings potential each year. Saving accounts become available in 2009, so planning for these deposits now allow you to be ready come the New Year.

One important item to note is the amounts contributed to these savings accounts are after tax dollars. There is no tax reduction when making contributions to these accounts. Therefore, accounts are most beneficial to those who have fully utilized their available RRSP contributions and are looking for another means of investing funds.

Planning is one of the key success factors to an appropriate investment strategy and should consider all sides. Therefore, ignoring the tax affect of a transaction may leave you bitter sweet when earnings are reduced by large tax bills. Therefore, take some time to consider all the options. Don't be afraid to ask questions and seek advice from specialists. The goal is to keep as many eggs in your basket as possible.

Kevin Keith would like to thank Ebony Verbonac of KPMG for her assistance with writing this article.

KPMG Lethbridge
kkeith@kpmg.ca