Investments can deliver a major source of income and tax implications for individuals. Each major type of investment income is subject to different tax treatment.
Understanding how your investments are taxed is an important consideration for investment planning since after-tax yield is more important than gross returns. The most common types of income most investors will receive are interest, dividends, and capital gains.
When subject to tax interest income can be taxed at a much higher rate than dividends and capital gains.
Inside a registered account, like an RRSP, RESP or TFSA, earnings are not taxed when they occur. The total withdrawal from an RRSP is subject to income tax, a portion of RESP withdrawals are taxable, but often do not incur a tax liability. No amount of a TFSA withdrawal is subject to income tax. For investment income that is subject to tax when it is earned, the effective income tax rate can vary widely for an individual.
Interest Income
Interest income refers to the compensation an individual receives from making funds available to another party. Interest income is typically earned on fixed income securities, such as bonds and Guaranteed Income Certificates (GICs). It is taxed at your marginal tax rate without any preferential tax treatment and is taxed annually even if it has not been withdrawn from the investment.
Example:
An investor buys a 10-year GIC that has agreed to pay him 4% annually. If the investor bought the GIC for $100, the contract stipulates that they will earn $4 of interest each year for the next 10 years. The investor must report the $4 of interest income on their income tax return each of those 10 years, even if the interest is paid to the investor at the end of the ten-year period.
Since interest income is reported as regular income, like employment income, it is the least favourable way to earn investment income if it is subject to income tax. Typically, GICs offer less risk than other investments to compensate for lower gross and after-tax returns.
Dividend Income
Dividend income is considered property income. A dividend is generally a distribution of corporate profit that has been divided among the corporation’s owners (i.e., shareholders). The Canadian government gives preferential tax treatment to Canadian Controlled Public Corporations (CCPC) in the form of a dividend income gross up and Dividend Tax Credit (DTC).
Taxpayers who receive eligible dividends are subject to a 38% dividend income gross up, which is then offset by a federal DTC worth 15.0198% of the total grossed up amount. Provinces offer a tax credit ranging from 8% to 12%, depending on the province, which further offsets tax owing from dividend income.
Example:
A shareholder of a Canadian Controlled Public Corporation is paid a dividend of $100. This income is an eligible dividend and is subject to the gross up and the DTC. The dividend would be grossed up 38%, so the income is now considered to be $138. The DTC would be 15.0198% of $138, the grossed-up amount, equaling $20.73. Therefore, the shareholder would report a dividend income of $138, but would have their federal taxes reduced by $20.73. In Ontario, for example, the provincial dividend tax credit is 10%, which provides a further reduction.
The rationale for the gross up and DTC is that dividends are paid to shareholders with after-tax corporate earnings. If there were no adjustments with the “top up” and DTC corporate profits would be taxed twice, once at the corporate level and again as a dividend. Dividends are a more tax efficient way to receive income than interest income. Dividend income is subject to tax in the period when they are paid. Since most dividends are paid throughout the year, often quarterly, a portion should be set aside to anticipate a future tax liability.
Different rules apply for dividends derived from non-Canadian and private corporations and can offer different tax treatment and advantages when professional tax expertise is employed.
Capital Gains
Capital gains are realized on equity investments (such as stocks) that appreciate. For example, if an investor bought a stock at $6 per share and sold at $10 per share, they would have earned a capital gain of $4. In Canada, only 50% of a capital gain is subject to income tax. In this example, only $2 of the gain would be taxed. Another desirable trait of capital gains income is that tax is not due until the investment is sold or deemed to have been sold. This provides the investor with a measure of control over the timing of taxes.
Important take away
It is important to ensure that investors understand their tax situation and the implications that different types of investment income can have on future taxes.
Financial, retirement and income planning should include the anticipated tax obligations at both the federal and provincial level. Ensuring an investor’s expert advisors understand overall objectives, risk tolerance and retirement timing can allow them to maximize after-tax returns.
