Why is Tax Important?
Not all Income is created equal...
It is important for investors to understand that not all types of investment income are taxed the same. Understanding this distinction is paramount, as different income types can either be very advantageous or very detrimental to your personal tax situation.
For example, income you receive in the form of interest from a bond investment or GIC is taxed at a higher overall rate than eligible Canadian dividend income or capital gains from the appreciation in value of a security or mutual fund investment.
For this reason, efficiently managing different types of income you receive as part of your total income can have a material effect on the amount of income tax that you pay, your after-tax return on your investments and on the wealth you are able to accumulate over time.
Different Types of Income, Different Tax Treatment
As your mutual funds invest in various financial instruments, they also generate different income types on your behalf. At the end of each year and periodically throughout the year, mutual funds may pay you, the investor, distributions of the funds earnings. These distributions are composed of the following types of income:
A capital gain or loss arises when a financial asset is disposed of for proceeds in excess of its cost. For example, if you purchase a stock for $1,000 and you sell it when the value is $1,500 your asset has appreciated $500 and your capital gain is $500. A capital loss will arise when the sale proceeds are less than the cost of the investment security. One half of a capital gain amount is included in taxable income in most situations.
A dividend is a distribution from a corporation's earnings, either directly from a company or through a mutual fund, to its shareholders. It is usually referenced on a per-share basis. For example, Company A pays a dividend of $1.00 per share to its shareholders out of its year-end earnings. If you owned 500 shares of Company A, you would have received $500 dividend. The dividend total is added to you income and is taxed accordingly.
Dividends from a Canadian corporation are subject to special federal and provincial rules which reduce the tax to the individual shareholder to reflect (more-or-less) the tax rates paid by the company. Changes proposed in 2006 have further reduced the tax rates on "eligible" dividends, which include dividends paid by Canadian public companies, including mutual fund corporations.
Dividends received from a foreign corporation do not receive such favourable tax treatment and are taxed like other higher rate sources such as employment or interest income, subject to a credit for any foreign withholding taxes that may have been paid.
Interest is income you earn as payment for the use of our money over a period of time. For example, if you deposit your money or savings into an interest-bearing account, you are lending your money in return for a fee. On $1,000 deposited at an interest rate of 4% for one year, you will receive $40 of interest income at the end of that year as payment for the use of your money. For a Canadian resident, interest income is taxed at the same rate as regular income like your salary.
Return of Capital
A number of corporate investment funds, including Natixis Tax-Managed Funds, allow an investor to receive his/her own investment back through periodic Return of Capital distributions. When your invested capital is returned, you may receive it without any immediate tax implications. However, for tax purposes, the return of capital does reduce the cost base of your investment and will increase your capital gain or decrease your capital loss when shares are eventually sold. Ongoing distributions may also eventually exceed your original cost of the investment. When this occurs, Return of Capital Distributions are taxed as capital gains.
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