Investment risk is a very broad and at times confusing subject. Risk can range from zero when invested in fully guaranteed low-yielding GIC products, to astronomical on penny stocks which have a much better chance of fading to zero than of producing a dramatic capital gain.
The challenge, of course, is to find the risk-reward balance that best fits each individual investor. This is easier said than done for most of us, unless we truly understand the various components that comprise investment risk.
I have previously touched on a number of these elements. High mutual fund fees accentuate market risk by siphoning several percentage points from portfolio value – with little evidence the high fees result in better performance for the investor. Another article dealt with the extra risk represented by currency fluctuations as they affect non-Canadian investments, and outlined how various currency-hedged exchange-traded fund products can alleviate this risk.
Yet another high-impact and often unnecessary investment risk is tax risk. Many investors simply fail to consider the impact of various income tax rules on their portfolio returns. Understanding those key features of Canadian taxation most important to investors is not difficult, nor are they numerous.
Firstly, any dividends paid by Canadian corporations are eligible for a dividend tax credit and very low effective tax rates. A B.C. resident with no other income, can earn up to $41,000 annually in Canadian dividends, yet pay zero tax. At most, he would pay 26 per cent on annual dividends above $127,000.
On the other hand, earned interest, whether on savings accounts, GICs, T-bills, bonds, or bond funds, as well as dividends earned from non-Canadian corporations, are taxed at the same rate as employment income.
The simple rule of thumb for a Canadian investor is to limit investments which generate interest or foreign dividends to holdings only in registered accounts – either a registered retirement savings plan, registered retirement income fund, or tax-free savings account. These accounts don’t attract taxes the year income is earned, regardless if it is interest, dividends or capital gains.
Non-registered investment accounts should contain products which primarily pay dividends from Canadian corporations. The low tax rate on Canadian dividends serves to significantly lower the tax cost for these non-registered accounts.
Astutely saving on taxes is guaranteed to improve portfolio returns. Thus, the normal market risk inherent to portfolios containing equities will be moderated.
A retired corporate executive, enjoying post-retirement as a financial consultant, Peter Dolezal is the author of three books. His most recent, The Smart Canadian Wealth-Builder, is now available at Tanner’s Books, and in other bookstores.