ADV-TaxAdvantaged_iTrade-(Advertorial Use Only)
Q: Can you recommend an investment strategy that provides capital gain which is has more favourable tax treatment compared to dividends?
A: Tax rates on interest, dividends and capital gains vary depending on the province where you file your return. With the exception of Alberta, tax rates on dividends are higher than on capital gains. However, the difference between the tax rates on dividends and capital gains is small when compared to the rates charged on interest. For example, in Ontario if you are in the top marginal tax bracket the following rates apply: interest-46.4%, capital gains-23.2%, eligible dividends-28.25% and ineligible dividends-32.6% [The Canada Revenue Agency web site discusses dividend eligibility in detail]
While tax minimization strategies are an important part of successful investment management for taxable investors, it is also important to consider the characteristics of the various investment alternatives. Historically, about 40% of the return on indices like the TSX and S&P 500 has come from reinvested dividends. As well, investment opportunities with the highest capital gains potential, such as non-dividend paying stocks, also tend to be the most volatile. Interest paid on bonds is taxed at the highest rate, but high quality bonds provide certain income and low volatility.
Our focus in equity portfolios is on stocks with a history of consistent and rising dividends. Conventional wisdom suggests that the best total return comes from non-dividend paying stocks. Recent work by Ned Davis Research debunks this widely held view. Their work examined the long term returns of four categories of U.S. stocks for the period 1972-2009: non-dividend payers, dividend cutters or eliminators, stable dividend payers and dividend growers and initiators. By far, the best total returns and lowest volatility came from stocks that initiated or increased dividends. The results of this analysis are shown below.
SOURCE: Ned Davis Research
Finally, unrealized capital gains do not attract any tax. One of the best strategies to minimize taxes is to avoid excessive trading. Of course there are good reasons to sell a stock and we will sell if the weighting has become too large, if the fundamentals have deteriorated or if there is a substantially better opportunity. Generally though, we do concentrate on maximizing long term after-tax returns.