Dividends, interest or yield?

As a Canadian, you might just want to throw your arms up at this glowing opinion from an American about the value we get for our relatively high tax rate. MSNBC’s Ester Bloom casually links the government services we get in return with higher reported happiness. It seems like a dubious linkage to a dubious metric. Today, Canadians are actually paying more for taxes than for basic necessities. That can’t be good.

Are we really getting value for the taxes we pay? That’s a big question for another day. But for Canadian investors, let’s deal with another question: how can we pay less tax? It matters whether we’re talking about dividends, interest or yield.

Obviously, the less tax you pay, the more you have left over to invest and hopefully earn a good return. How you earn that return matters to the Canada Revenue Agency (and ultimately, to your wallet. For instance, Canadian bond holders who would otherwise earn a positive return from a yield to maturity watch as the CRA turns their loss prevention strategy into a loss guarantee. The return gets treated as earned income, at a higher tax rate than a capital gain.

So what’s the difference between dividends, interest and yield? Investors sometimes use these terms interchangeably. But they also don’t always know how the differences between them can affect performance or taxation.

Here, we’ll break these concepts down for you. For another take on this topic, check out this primer from our CEO on how Canada taxes your investments.

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But first, a cordial caveat about cash flow

For WealthBar portfolios, we complement price appreciation with cash flow. Cash flow investing delivers accelerated wealth building. It does this while assuring flexibility to rebalance. This provides protection against market volatility and peace of mind for investors that they are earning sustainable income.

For most clients this income is sheltered in a registered account (TFSA or RRSP) and there are limited consequences. For non-registered clients, there are tax implications – which we’ll go into elsewhere.

Dividends

“A dividend is a payment made by a corporation to its shareholders, usually as a distribution of profits. Wikipedia

A company that pays dividends… well, that is a sign of a good, successful company. They’re not just stockpiling the returns from good years. They’re not throwing it into an ever-growing corporate war chest or slush fund (or multi-million dollar bonuses for the executive team).

Instead, they’re showing good faith to their investors who provided the capital to enable their success. One could argue that this is just one way of being a good corporate citizen.

When the distribution comes in the form of cash, that cash flow can be deployed for other uses. It’s possible to rebalance a portfolio using those resources by focusing on other buying opportunities.

Even better: Canadian eligible dividends are taxed at preferable rates when compared to income! Less taxation means more money left over to invest and provide a bigger return.

Interest

“Interest is payment from a borrower or deposit-taking financial institution to a lender or depositor of an amount above repayment of the principal sum.” – Wikipedia

The main thing investors need to know about interest: for the purpose of taxation it is treated the same way as other earned income. This explains the growing popularity of TFSAs; the interest earned on these accounts is not subject to taxation (though the principal from the contributed amount is still subject to taxation in the usual way for other income).

Yield

Now that we know what dividends and interest are, yield is quite simple to understand: it is the income return on an investment, typically expressed either as a dividend or as interest. It’s a more general term – but it’s not technically a substitute for either of them.

Bonus Section. Return of capital (ROC)

Return of capital means principal payments that go to shareholders or partners. As a business or investment grows, the capital gains that are above its taxable income go back to these stakeholders, usually at the same price for which is was purchased.

For the purpose of the investor, the main point is that these capital gains are taxed at the most favourable rate. As this Moneysense article noted, the amount taxed at a marginal rate can vary by province and income tax bracket. For instance, “For a Canadian in a 33% tax bracket for example, a $25,000 taxable capital gain would result in $8,250 taxes owing. The remaining $41,750 is the investors’ to keep.”

Contrary to popular belief, capital gains are not taxed at your marginal tax rate. Only half (50%) of the capital gain on any given sale is taxed all at your marginal tax rate (which varies by province). On a capital gain of $50,000 for instance, only half of that, or $25,000, would be taxable.

Finance 101 Advanced Lesson Review: Dividends, interest or yield

Yield, or returns on investment, can be expressed in different ways, through dividends or interest. These have different tax implications for investors. Portfolio managers are highly attuned to these differences, understanding that tax mitigation is a key strategy for wealth conversation and growth over time.

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