Archive for the 'Understanding How Income Is Taxed' Category

03
Feb

Understanding how investment income is taxed.

By Shamsh Moosa 0 Comments
Categories: Understanding How Income Is Taxed

When investing outside of the tax-sheltered environment of an RRSP or RRIF, it is important to consider an investment’s after tax rate of return in conjunction with your risk tolerance and investment goals. To reduce the tax paid on your investment income, you should consider investments that generate capital gains or Canadian source dividends as they are taxed more favourably than interest income.

Interest income earned from investments such as T-Bills, Bonds, and GICs are generally taxed at the highest marginal tax rate. The marginal tax rate is the rate applied to each additional dollar of income you earn.

Dividends earned from a Canadian Corporation are taxed at a lower rate than interest income. This is because dividends are eligible for a dividend tax credit, which recognizes that the corporation has already paid tax on the income that is being distributed to shareholders.  This, however, only applies to dividends from a Canadian corporation. Dividends paid from a foreign corporation are not eligible for the dividend tax credit.

Capital gains result when you sell an asset for more than you paid for it. This gain is offset by any losses and can be further reduced by any expenses that are incurred by the purchase or sale of the asset. The result is your net capital gain, however only 50 percent of that net gain is taxable at the appropriate federal and provincial rates.

The table below illustrates the tax treatment on the different types of a $1000 investment income; including interest, dividends and capital gains.

Income Earned Table

03
Feb

Dividends Can Help Boost Long-Term Performance

By Shamsh Moosa 0 Comments
Categories: Understanding How Income Is Taxed

Conservative investors have long valued dividend stocks for their steady, predictable income and their stability in volatile markets. While clearly attractive in the short term, dividend income can also boost long-term investment returns.

Focusing on dividends can be a wise strategy for those seeking long-term capital appreciation in their portfolios without a high level of risk, as well as for investors who are close to retirement and require regular income.

Conventional wisdom is that dividend investors sacrifice capital gains for income. However, over time, dividends have played a major part in generating returns for investors. According to Standard & Poor’s research, dividends have contributed 30% of the total return for the S&P/TSX Composite Index since 1956.

Dividend investments have the flexibility to support many goals, as payouts can be reinvested in the same company, invested elsewhere, or used to generate regular cash flow. Dividend tax credits, made more generous in 2006, give favoured tax treatment to eligible dividend income paid out by Canadian companies.

Helps build returns
The advantages of this strategy can be magnified even further by investing in companies with a record of regularly increasing their payouts. For example, a stock purchased at $10, with a 30-cent annual dividend, would have a 3% yield at the purchase price. However, if that company raised its dividend by 10% in each of the next three years, the dividend would rise to almost 40 cents, or 4% of the original purchase price, producing overall gains year after year.

Rising dividend payouts can also be used to identify companies that are in good corporate health. Companies that consistently increase their dividends tend to have strong fundamentals, stable earnings, and relatively high levels of sustainable free cash flow. These companies also tend to fare better than average during market downturns.
While more research is always necessary when considering a new investment, dividend history is certainly a useful gauge.

Tied to stock performance
Research also suggests that rising dividends go hand in hand with superior stock performance. The recently created Standard & Poor’s Canadian Dividend Aristocrats index tracks a portfolio of companies that have increased their dividends for at least seven consecutive years. The index’s members have more sustainable payout ratios, have shown better returns on equity, and have higher earnings and dividend growth than the Canadian market overall.

In the U.S., this out-performance is even more dramatic. The S&P High-Yield Dividend Aristocrats index, composed of 50 companies that have increased their dividends for 25 consecutive years, outperformed the S&P 500 index by a wide margin in the seven-year period to the end of
2006. And the S&P Aristocrats index rose during the “down” years of 2000 and 2001, while the S&P 500 declined materially.

What to look for
In Canada, the list of the strongest dividend-payers includes the major banks and financial companies, utilities, energy companies, and real estate companies. Some income trusts and real estate investment trusts (REITs) also have a record of raising distributions; however, more care is necessary with trusts because of their higher volatility.

In the U.S., financial companies also lead the list, along with a number of companies in the consumer staples, consumer discretionary, health care, and industrials sectors. More favour-able tax laws and soaring corporate profits have seen U.S. dividends rise significantly in recent years — a trend that ScotiaMcLeod analysts believe is likely to continue. With cash levels at record highs, we expect large U.S. corporations to continue returning cash to shareholders at record levels.

Most investors identify strong returns with rising stock prices and hefty capital gains. However, it’s worth considering the role of dividends when structuring your portfolio. Investing with an eye to steady and rising dividends can create a portfolio whose long-term returns exceed those based solely on capital gains, with less volatility. If you’d like to review the role dividends play in your portfolio, please contact me.

Top dividend-paying sectors
Energy 12.65%
Consumer Staples 6.49%
Consumer Discretionary 2.28%
Utilities 14.45%
Industrials 2.95%
Financials 61.19%

Source: Standard & Poor’s, 2007; total may not equal 100% because of rounding.
The financials, utilities, and energy sectors provide the broadest range of quality dividend stocks, as illustrated in this breakdown of companies in the S&P/TSX Canadian Dividend Aristocrats index. This benchmark measures the performance of 35 constituent companies that have consistently increased their dividends every year for at least seven years.

Additional Notes
Maximize your dividends with a DRIP.
One way to maximize your returns is to reinvest dividends into new shares of the company. The easiest way to do this is through a Dividend Reinvestment Plan, or DRIP. Offered by many major companies, these plans have several benefits.

•    Convenience: Dividends are reinvested automatically, eliminating the need to make multiple trades.

•    Cost savings: There is no commission on the purchase of new shares with the dividend proceeds. There may be trading fees, however, and tax will still be payable on the dividends, even though no cash distribution is received.

•    Easy to set up: A DRIP may be administered by the company itself, or by an agent or broker. Joining the plan usually involves completing an authorization form; it may be necessary to have your shares registered in your name.

I can assist you in finding out whether the companies in which you invest have a DRIP, and to help you make the necessary application.

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