Different types of investments are subject to different tax treatments.
Bonds primarily produce interest income, in the form of their coupon payments. Some stocks pay a dividend, which can be eligible for a dividend tax credit. And then there are capital gains, which arise when any investment is sold for more than the cost to purchase.
The least favourable tax treatment goes to interest income, which is fully taxed in both Canada and the U.S. — meaning that you must pay tax on 100% of the interest income you receive outside of tax-sheltered plans.
Dividend income is treated somewhat more favourably, especially if those dividends qualify for a tax credit, which would reduce the taxable portion of the total amount of dividends received. Foreign stock dividends are not eligible for any tax credit and there is a subset of domestic securities whose dividends also do not qualify.
Capital gains are the most favourably taxed of all types of investment income. In Canada it’s a 50% inclusion rate at the individual’s marginal tax rate. Meanwhile, the tax rate on long-term capital gains varies in the U.S., from zero to 20%, and short-term gains are taxed at the same rate as ordinary income. The capital gain amount is the difference between the profits from a sale and the adjusted cost base of the investment position.
The other type of income we should mention is return of capital, which happens when a payment or return is received from an investment, but is not considered a taxable event. This does affect the adjusted cost base (ACB) of the investment, so while no immediate tax liability is created, it’s merely being deferred until a later date (typically when the investment is sold).
The type of income is important when looking at the overall tax efficiency of a portfolio, and investors would be wise to strike a comfortable balance between limiting their tax hit and maintaining a portfolio that is in keeping with their goals, objectives and risk tolerance.