Most investments can be classified as either debt or equity and both have their pros and cons. We encourage most investors to have a balanced approach, meaning a mixture of both debt and equity investments.
With debt investments you are essentially lending your money to a corporation, municipality, province, or government. There are many different names for debt investments, and the broad category is often referred to as fixed income. The types of investments that fall into this category are bonds, GICs and term deposits. Debt investments produce primarily interest income but can produce a capital gain (loss) if traded.
Pros of debt investments are that income is generally more certain, they reduce volatility, and provide capital preservation.
Cons of debt investments are that income is fully taxable in a non-registered account, they do not adequately protect you from inflation, and rates are currently very low.
With equity investments, you are purchasing a class of shares of a company. The two main types are common shares and preferred shares. Three differences between common and preferred shares deal with how they rank in the event of a company’s failure, their right to dividends (if any), and exposure to the success (or lack their of) of the company. Equity investments may produce dividend income and/or capital gains (loss).
Pros of equity investments are that growth can be deferred if not sold, dividends are taxed more favourably than interest income, returns have the potential to be higher than debt investments, and protection against inflation.
Cons of equity investments are the volatility in the stock market, and the risk of losing capital.
As an investor it is always important to factor in the tax consequences of your investments. After all, it is the amount that ends up in your pocket that counts, and not the gross income received. The following illustrates the tax consequences of a top tax bracket individual (43.7 per cent marginal tax rate) who resides in British Columbia, and receives $1,000 through interest income, dividend income, and capital gains in a taxable account.
|Description||Amount||Taxable Portion||Tax||Tax Credits|
|Capital Gains||$1,000||$ 500||$(219)||N/A||$781|
The above table becomes relevant as soon as you hold investments outside of a registered account, such as a cash, margin or corporate account. When you have non-registered investments, you should structure your portfolio in a manner that creates the most tax efficiency.
One example of this is to hold debt investments within an RRSP as all interest income would be tax sheltered. Your equity investments should be held in your non-registered account to take advantage of the taxation of dividend income, tax deferred growth on investments not sold, and eventual capital gain (loss) treatment when sold.
Value oriented investors are well aware of the positive effects dividends have had on their total returns over time. A company’s board of directors may decide to pay a dividend to one or more of their class of shares. They then select a date – referred to as the record date – to determine which shareholders are eligible to receive the dividend.
Dividends are usually paid quarterly and are more common among mature businesses that do not require all of their profits to fund future growth. Growth oriented companies are less likely to pay dividends as they retain their capital to fund internal growth and in some cases make acquisitions.
Dividends are normally stated as a monetary amount per share. If the company pays this quarterly, then the total dividends for the year are $2.00. If the share price is currently at $80, then the yield is 2.5 per cent (2/80). If the price of the share increases to $100, then the yield drops to 2 per cent (2/100). If the price of the share decreases to $60, then the yield increases to 3.3 per cent (2/60).
The dividend gross-up and tax credit often confuses investors who are trying to do their income tax return for the first time. The common question is: “if I received $100 in dividends, why am I taxed as if I received $145?”
This is called the dividend gross up and this is the amount you are first taxed on. The highest marginal tax rate (combined provincial and federal) in British Columbia is 43.7 per cent. Lower down on your tax return you have the dividend tax credit.
The most important component to note is that “credits” are better than deductions. A credit is generally a dollar for dollar reduction from taxes payable.
One of the most underused tax strategies in Canada is the fact that gains on equity investments are not taxed until they are sold. This tax friendly rule encourages people to make equity investments for the long term. A part of the plan that we help set up for clients is to purchase select equities in a non-registered account and hold them for the longer term to take advantage of this rule.
From a tax standpoint, equity investments are superior. So why not have 100 per cent equities?
From a risk standpoint, it is important to have balance. In our opinion, stock market risk is greater than interest rate and inflation risk.
The key to any portfolio, is managing your own risk and comfort level. Your risk tolerance, time horizon, need for cash flow, and current capital levels all need to be considered prior to determining a suitable mix between debt and equity investments.