How are my investments taxed?
How can we pay less tax? Well, it matters whether we’re talking about interest, capital gains or dividends. When you get your annual tax forms from the bank, company or investment firm, they will use one or more of those terms to describe the investment income you earned.
Type of income
Where this income might come from
Tax rate
Interest income
From an investment account, payment on a loan that you provided, interest-bearing savings account, etc.
Your usual income tax rate
Dividend
Paid by a company to shareholders out of profits. Can come from individual companies’ stock or investment funds.
Highly variable. See full explanation below.
Capital gains
From the rise in value from the time you bought an asset until you sold it (eg. selling a house).
Half of your usual income tax rate.
The type of investment income — whether it’s interest, capital gain or dividend — and type of account it’s in, can affect how much tax you pay the Canada Revenue Agency.
Obviously, the less tax you pay, the more you have left over to invest and hopefully earn a good return.
So what’s the difference? Here, we’ll break these concepts down for you.
Interest
The main thing investors need to know about interest: for taxation purposes, it is treated the same way as other earned income, like from your day job.
This explains the growing popularity of TFSAs used as investment accounts (not just interest-bearing savings accounts); the interest earned on these accounts is not subject to taxation. You make contributions to a TFSA with after-tax dollars (you’ve already paid tax on that money when you earned it). So, when you eventually take it out, there’s no more income tax to pay!
Dividends
A company that pays dividends… well, that is a sign of a good, successful company. They’re not just stockpiling the returns from good years. They’re not throwing it into an ever-growing corporate war chest or slush fund. Instead, they’re showing good faith to their investors who provided the capital to enable their success.
Canadian eligible dividends are taxed at preferable rates when compared to income! Less taxation means more money left over to invest and provide a bigger return, through the power of compounding.
Capital gains
Did you invest in something that is now worth more than the price you paid when you bought it? When you sell your investments for a gain, those gains become real (instead of just gains on paper) and are taxed. The good news – those realized capital gains are taxed at the most favourable rate!
What makes the tax treatment of capital gains so favourable? Well, only HALF of your gain is taxed at your marginal tax rate.
Let’s say your marginal tax rate (the tax rate you pay on the last dollar you earn) is 50%. If you earned $1,000 of interest, that would mean you pay $500 of tax. But if you instead earned $1,000 of realised capital gains, only half of that amount is taxed and you would only have $250 of taxes to pay.
Which account type makes sense for which kind of investment income?
Type of investment Income
Best type of investment account for that investment income
Interest income (and other income that’s taxed like ordinary income)
Tax-deferred accounts (eg. RRSP) or tax-sheltered accounts (eg. TFSA)
Capital gains
Non-registered accounts
Dividends
Non-registered accounts for eligible dividends (which get the benefit of lower tax rates).
Tax-deferred accounts for non-eligible dividends (which don’t get the benefit).
Dividends can be issued by corporations, from large publicly traded companies to small privately owned companies. For small business owners, issuing dividends instead of – or in addition to – taking a salary can be part of a tax smart strategy.
Finance 101 Advanced Lesson Review: Dividends, interest, and capital gains
Investment income can be expressed in different ways: through interest, capital gains or dividends. The less tax you pay, the easier it is to grow your money over time!
Still have questions about how your investments are taxed or which account type is best for you? Contact a CI Direct Investing financial adviser.