How Your Investment Income is Taxed
Now that you’ve been working on your income tax return, it’s a good idea to do a review and identify any missed opportunities and changes you may be able to make this year.
In particular, you should take a look at your investments and make sure they are still meeting your needs in a tax efficient manner.
If you invest in non-registered accounts, it’s important to know that they have no special tax status the way registered accounts do.
Moreover, tax-sheltered plans have their own tax rules when it comes to certain types of investments.
Regardless of the tax bracket you are in, it is important to know that different types of income are taxed at different rates – and that means the amount of money you keep will be different, depending on the type of income, type of accounts, province of residence and foreign sources and their tax treaties. The CRA doesn’t make it easy for us.
Here’s a quick review of how various types of investments in your portfolio are taxed.
Interest income is 100% taxed as regular income at your highest marginal tax rate. Sources are savings accounts, GICs and term deposits, and bonds.
You must also claim accrued interest from compound interest GICs, and strip bonds, even though you haven’t yet received it.
There are no tax breaks, which is why financial advisers recommend holding these vehicles in your registered accounts – RRSP, RRIF, RESP, and TFSA’s.
Many investors hold shares in publicly traded Canadian corporations in their non-registered accounts in order to benefit from the special tax credits on eligible dividends. This means that dividend income will be taxed at a lower rate than the same amount of interest income. The dividend tax credit is actually two credits – one federal and one provincial. The provincial tax credit varies depending on where you live in Canada.
This tax credit is not available for dividends paid to registered accounts.
However, you don’t claim the money you actually receive. First, the amount is “grossed up” by 38%, and then the tax credit (approximately 15%) is calculated and deducted as part of your basic federal tax calculation. That’s because corporate taxes have already been paid on a company’s earnings and dividend are paid from their after-tax earnings.
In many cases this is a benefit, but it can also cause problems if the amount is significant. The “grossed up” amount becomes part of your net income, which means it could have an impact on your eligibility for various income-tested tax credits such as GST and the age credit. It could also put some people into OAS clawback territory – for income that’s never even received.
In addition, each province has a different tax rate for dividend income. If your income is below a certain threshold it may even be a negative amount.
For example, the tax rate on eligible dividends amount:
- Ontario – on the first $43,906 of taxable income it is -6.86%
- British Columbia – on the first $41,725 of taxable income it is -9.6%
How about that?
If you sell your profitable shares from a non-registered account, you have to pay capital gains tax on the profit you make when you sell them. Half of the capital gains are subject to tax.
You can reduce this amount further by deducting any capital losses (from up to 3 preceding years) and legitimate expenses such as brokerage commissions incurred.
Examples of tax rates on capital gains are:
- Ontario – up to $43,906 of taxable income it’s 10.3%
- British Columbia – up to $41,725 of taxable income it’s 10.3%
Since your capital gains tax rate is determined by your marginal tax rate, you need to pay attention to your overall income in each calendar year. If you’ve owned shares for a long period of time you may have substantial gains. It’s a good idea to sell these shares over a period of time at a lower marginal tax rate instead of all at once and giving more to the tax man.
Another strategy is to make a charitable donation of your shares. This entitles you to a charitable receipt of the entire value for tax purposes and doesn’t trigger any capital gains tax.
Capital gains in RRSP’s, RRIF’s, and RESP’s are treated as regular income on withdrawal, so you lose the lower overall tax rate. Capital gains earned in TFSA’s are not taxed on withdrawal, but you can’t benefit from any capital losses either.
Return of capital
Some investment income you receive may include return of capital. This often occurs with distributions from REITs, and some mutual funds and ETFs.
Tax is not immediately assessed on return of capital, but it does change your adjusted cost base (ACB), so that when you eventually sell your shares the capital gain (or loss) will be based on the ACB, not the price you originally paid.
Large U.S. corporations pay very attractive dividends and are particularly sought after by investors wanting income.
The dividend tax credit does not apply to U.S. dividends. They are treated as ordinary income and taxed at your marginal rate just like interest payments. Also, 15% of the dividend amount on common stocks will be deducted at the source. This withholding tax is not applied to retirement accounts (RRSP, RRIF) but it does to TFSAs (so, in this case they are not really tax free).
You can claim the withholding tax as a foreign tax credit in non-registered accounts only.
American Depository Receipts (ADR)
American depository receipts are shares of foreign companies such as Samsung, Royal Dutch Shell, and Nestle that trade as proxies on the New York Stock Exchange. They are not treated as U.S. stocks for tax purposes. Withholding tax on dividends varies according to the country the company is incorporated in and any tax treaty between that country and Canada.
ADR dividends paid into retirement plans do not benefit from the tax exemptions that apply to US dividends and you won’t be able to recover it with the foreign tax credit.
If you are considering these investments, find out what the applicable withholding rate is first. You won’t want these in your RRSP, RRIF or TFSA.
Related: How Retirement Can Affect Your Taxes
The bottom line
Take some time to review not only your investments, but also the accounts they are held in. What may have worked well at one time in your life may not be suitable at this time.
Retirees need to pay particular attention to fluctuation annual income as a large increase in one year not only means higher taxes but can trigger clawbacks of government income-based benefits such as Old Age Security.
And while you shouldn’t just let taxes dictate your investing decisions, you want to make sure you are optimizing your returns, not losing them to the taxman.