Why Pay Tax On Money You Never See?

Based on their in-depth knowledge of the investing habits of Canadians, investment professionals estimate that half to two-thirds of all investable wealth in Canada is held outside registered savings plans (RSPs). That's understandable because most conservative investors take a practical approach to investing that seeks to reduce risk and volatility while delivering a desired level of returns over the long term - in other words, creating and maintaining a properly diversified portfolio with the best prospects for long term growth.

Often, those investors seek the safety of 'guaranteed' or 'fixed-income' investments such as bonds, mortgages, Guaranteed Investment Certificates (GICs), and other interest-generating securities, which generally provide a stream of income while preserving capital. (Fixed-income investments are one of the three basic types of investments; the other two are cash and equity).

The problem is that interest income is the least tax-efficient type of income. Every $1 of interest income is fully taxable, just the same as your employment income. So, if you are heavily invested in interest-generating investments, you are likely to incur a stiff tax liability each year -- even though you may not currently need that income. And, your tax liability becomes even more problematic if your investments produce taxable income each year but this income is automatically reinvested (or compounded), creating a tax bill with no corresponding cash flow to pay the tax.

It's your after-tax return that matters

Even though your interest income investments may be delivering a significant return, that return may also be significantly reduced by the high rate of taxes you must pay. One option is to move a portion of your non-registered investments into 'equities' that provide income from dividends and capital gains, which are taxed at a much more favourable rate than interest income. For example, any realized capital gains you receive from an equity investment are taxed at just 50% -- in other words, only 50 cents of every dollar of the capital gain is subject to tax.

Dividend income also benefits from federal and provincial tax credits that provide a fair degree of tax relief.