A recent study shows less than half of Canadian taxpayers understand how their investments are taxed. While I know that this statistic is much too low when it comes to you well-informed Dollars and Sense readers, perhaps a quick review is still in order.
Here are the basics for investment income earned on non-registered investment accounts. This is money outside of RRSP, RRIF, TFSA or other registered accounts.
Interest income is paid on savings and deposit accounts, GICs, bonds and other fixed-income investments. It will also be paid to you by the Canada Revenue Agency (CRA) on your tax refund, if they take as long to process as they have mine.
Interest is taxed at your top marginal tax rate (MTR). For example, if your taxable income is between roughly $31,000 and $43,000 after deductions, your MTR is 27.75 per cent in Manitoba. The MTR gets higher as your taxable income rises, maxing out at 46.4 per cent on taxable income above $136,000.
So, $1000 of interest income earned outside of RRSPs or TFSAs could cost you between $277 and $460 of tax.
Capital gains are more complicated, but still easy to understand. There is no tax on unrealized capital gains. As long as you continue to own "capital property" without selling it, no gain is realized and no gain is reported on your return.
(The exception might be a "deemed disposition," where CRA deems you have sold).
Capital property includes stocks, mutual funds, real estate (including second residences) or business assets.
When you sell capital property at a profit, only half of that profit must be included in income. Therefore, the tax on realized capital gains is exactly half the amount of tax on interest income of the same amount.
Each year, you must account for the net amount of your capital gains and losses. If the net amount is negative, then you have capital losses that can be carried forward to offset capital gains in the future, or carried back to any of the three previous tax years, to offset gains you claimed on those returns.
This ability to carry back capital losses can be very useful, and quite gratifying when you recover taxes you thought were gone forever. We spend a lot of time every November reviewing clients' accounts for realized and unrealized gains and reviewing their history of claims to take full advantage of the opportunities available.
Dividends are amounts paid by corporations to their shareholders from the after-tax profits of the company. Since the company has already paid income taxes on the profits, the tax system reduces the effective tax rate the shareholder pays on his or her personal tax return. This process is called integration.
It results in a very complicated system, with "eligible" dividends (paid by publicly traded corporations on the shares you buy as an investor) and "non-eligible" dividends, paid on small business corporations that have paid a lower rate of corporate tax.
Cash (or deemed) dividends received are "grossed-up" by 38 per cent, and this grossed-up amount is claimed on your tax return. So, a $100 dividend results in a claim of $138.
In return, though, a dividend tax credit of 6/11 of the grossed up amount is used to reduce income taxes. This results in a much lower effective rate of tax on dividends compared to interest. In fact, for people in the lowest tax bracket or those with only dividend income, there may be net zero tax.
The rate for eligible dividends in the first tax bracket is about 6.5 per cent, versus the 27.75 per cent applied to interest income. At the very top rate, dividends are taxed at 32 per cent versus 46 per cent for interest income.
The gross-up and inclusion rates for private corporations have changed in 2014, to 18 per cent and 13/18 of the grossed-up amount, respectively, so please take note if you are the owner of a small business corporation.
Knowing how investments are taxed can help you minimize your tax bill for a given amount of investment income, consistent with your personal risk tolerance and asset mix. A good basic to remember is to shelter interest income inside your RRSP, RRIF, TFSA or other registered account.
For even more fun, review your income tax return line by line to see how much tax you actually paid on investment income. It could be an eye-opener.
Dollars and Sense is meant as an introduction to this topic and should not in any way be construed as a replacement for personalized professional advice.
David Christianson, BA, CFP, R.F.P., TEP, CIM is a financial planner and adviser with Christianson Wealth Advisors, a vice-president with National Bank Financial Wealth Management, and author of the book Managing the Bull, A No-Nonsense Guide to Personal Finance.