Different types of investments provide different types of returns which are taxed differently. It is important to know about taxes on investment returns before deciding on what type of investments to make. First you need to know that taxes on investment returns are different depending if the investment is held in a government registered account. For Canadians that may be an RRSP, TFSA, RESP, etc.
Taxes on Investments not held in a Registered account
Interest earned is considered income and is taxed as regular income. Each additional dollar of interest earned is taxed at your marginal tax rate.
Bond interest is also considered income and is taxed as regular income at your marginal tax rate.
Stocks can provide two types of return, capital gains realized when you sell the stock for more that you paid for it, and dividends paid to you on regular intervals (monthly, quarterly or annually) for owning (holding) the stocks. Capital gains (depending on the country you live in) may be taxed at 50% of regular income. Dividends are little more complicated but are often a very good deal depending on the country you live in and the country of the stock.
It is important to understand how dividends are taxed because usually they receive preferred tax treatment. That is because the company paying the dividend has already paid tax associated with it, so you effectively pay only the difference between what they paid and your marginal tax rate. As such dividends may be taxed at a low effective rate, even below zero percent for low income persons – yes they get a real refund. For high income persons the tax on dividends is usually less than your marginal tax rate. It is for this reason (lower taxes) and the fact that dividends tend to be regular and consistent despite market fluctuations that people like investment returns in the form of dividends.
ETFs or mutual funds can provide capital gains and dividends.
Taxes on Investment held within a registered account
Any investment held within a registered plan will be taxed according the rules of the plan, which means they can be taxed in a completely different way than if they were not in a registered plan. The following examples are for Canadians.
All amounts (original capital and returns) withdrawn from RRSPs are taxed as regular income and therefore are taxed at the regular rate at the time of withdrawal. RRSPs can provide a tax advantage but only if you are convinced that your marginal tax rate when you make withdrawals from the RRSP (or its conversion to a RRIF) is expected to be lower than when you contribute.
All amounts (original capital and returns) withdrawn from TFSAs are not taxable at all (ever). TFSAs are a preferred investment vehicle from a tax perspective, just stay within the contribution limits.
Investment returns and grants from RESPs (the portion not including the original capital) are taxable to the student (beneficiary) as regular income at the time of withdrawal if the student is in school. Also, if the student is in school then the original capital portion can be withdrawn by the RESP holder (contributor) and is not taxable. While the concept of RESPs is very simple and the contribution and grant rules are straight forward it can be complex at withdrawal time. That will be a topic for another article.