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Calculating Interest-Rate Equivalents

Trying to figure out the best bet for your money when it comes to investments can get complicated. As you are probably aware, if you receive a dollar of income, the amount of income tax you must pay will depend on that dollar's origin. (Is it from rental properties, interest earned from a bond or GIC, dividends received from a share, capital gains from the sale of an asset, employment income, etc.?) So the different income tax treatment for different types of income makes it difficult for individuals to compare different investment opportunities.

Apples to apples

It would be easy if we were always comparing apples to apples in the world of investment options. But more often we’re not.

For example, what if you would like to compare an investment in preferred shares with an investment in bonds? Should you invest in a 4.0% preferred share or a 4.25% bond? Which is better? Dividend income is taxed at a much lower rate than interest income. So how do you compare the two types of investments? These are the types of questions that leave a lot of investors scratching their heads.

Finding the after-tax interest-rate equivalent

One method you can use to answer these questions is to calculate an after-tax, interest-rate equivalent for the preferred share in order to create a level playing field (i.e. you always want to compare apples to apples). This is a simple way to convert the preferred share's dividend yield into an after-tax interest rate so you can compare the after-tax income from the preferred share with that of the bond.

The calculation of the after-tax interest-rate equivalent enables you to convert the dividend yield into an after-tax interest yield. This after-tax interest yield can then be used as a gauge when looking at the interest rate offered by a bond or Guaranteed Investment Certificate (GIC).

Example: Say you're trying to decide whether you should invest the cash balance in your taxable investment account in preferred shares or a bond. Let's say you're looking at a preferred share that pays $1.00 in dividends per year, per share, for a yield equal to 4.00% and you've found a longer-term corporate bond that pays a 4.25% interest yield. On the surface the bond looks more attractive paying 4.25%. But you also realize that you will pay more income tax on the bond's interest income than you would on the preferred share's dividend income. So how do you compare these two on an after-tax basis? It’s a simple math equation.

Note: You can use the Interest-Rate Equivalent calculator to make quick calculations.

How to do the math

To compare these two different types of income streams, on an after-tax basis, you will need to calculate an interest-rate equivalent annual return for the preferred share and then compare this number with the bond's annual interest rate:

  • Calculate the preferred share's interest-rate equivalent by multiplying the dividend yield by an appropriate multiplier that is generated for taxpayers at the top income tax bracket for each province. (See the table below for a summary of the multipliers.)

Example: Here’s what that mathematical equation would look like: After-Tax Interest-Rate Equivalent = Dividend Yield X Multiplier

If we assume you live in British Columbia and you are paying income tax at the highest marginal income tax bracket, you can use the table below to obtain an appropriate multiplier (where B.C.'s Multiplier = 1.3124). Therefore, in our example of the preferred share with a dividend yield of 4.00%, you can calculate the preferred share's after-tax interest-rate equivalent as the following:

4.00%(dividend yield) X 1.3124(multiplier) = 5.2496%

Conclusion: compare the results

In the example above we see that for B.C. investors to have the same after-tax income from a bond investment as they would from the 4.00% preferred share, the bond would need to pay a rate of interest equal to 5.25% per year. If the bond investment pays less than 5.25%, then the 4.00% preferred share offers a better after-tax income.

Note: The after-tax, interest-rate equivalent calculation does not include any capital gains or losses that may occur from either a preferred share or bond investment. The calculation simply enables an investor to compare the after-tax annual income streams received.

Additional Note: For a more in-depth discussion on the taxation of dividend income, you can visit MoneySense and read their article titled Delectable dividends.

 

Multipliers for highest income tax brackets - 2013
Alberta1.3231
British Columbia1.3183
Manitoba1.2638
New Brunswick1.3674
Newfoundland1.3437
Nova Scotia1.2788
Ontario ($135,054-$509,000)1.3148
Prince Edward Island1.3547
Quebec1.2948
Saskatchewan1.3427
Yukon1.4595
Source: Scotia Mcleod 

 

Multipliers for the highest income tax brackets - 2012
Alberta1.3231
British Columbia1.3124
Manitoba1.3410
New Brunswick1.3674
Newfoundland1.3437
Nova Scotia1.2788
Ontario1.3148
Prince Edward Island1.3547
Quebec1.2976
Saskatchewan1.3427
Yukon1.4595
Source: Scotia Mcleod

 

Multipliers for the highest income tax brackets - 2011
Alberta1.3489
British Columbia1.3515
Manitoba1.3668
New Brunswick1.3940
Newfoundland1.3698
Northwest Territories1.3989
Nova Scotia1.3101
Nunavut1.2482
Ontario1.3400
Prince Edward Island1.3808
Quebec1.3161
Saskatchewan1.3686
Yukon1.4882
Source: Scotia Mcleod 

  

Multipliers for the highest income tax brackets - 2010
Alberta1.3790
British Columbia1.3952
Manitoba1.3976
New Brunswick1.4130
Newfoundland1.3627
Northwest Territories1.4081
Nova Scotia1.3567
Nunavut1.2835
Ontario1.3702
Prince Edward Island1.4068
Quebec1.3387
Saskatchewan1.3993
Yukon1.4097
 Source: Scotia Mcleod

A look back at historic multipliers.....

Multipliers for the highest income tax brackets - 2001
Alberta1.244
British Columbia1.247
Manitoba1.234
New Brunswick1.286
Newfoundland1.325
Northwest Territories1.237
Nova Scotia1.292
NunavutN/A
Ontario1.282
Prince Edward Island1.293
Quebec1.297
Saskatchewan1.280
Yukon1.246
Source: RBC Dominion Securities
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