How are my investments taxed?
How can you pay less tax? Great question! Well, it matters whether we’re talking about interest, dividends, capital gains or return of capital. When you get your annual tax slips from your financial institution, they’ll use one or more of those terms to describe the investment income you’ve earned.
Type of income
Where this income might come from
From an investment account, payment on a loan that you provided, interest-bearing savings account, etc.
Your usual income tax rate
Paid by a company to shareholders out of profits. Can come from individual companies’ stock or investment funds.
Highly variable. See full explanation below.
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.
Return of capital
Distributed by investment funds as a partial return of your original invested capital
Not taxable right away, but will increase capital gains (or reduce capital losses) when selling your stake in the fund
Let’s consider how these income types differ.
Interest is taxed at a higher rate than other income types – just like the income you earn from your job.
This helps explain the growing popularity of TFSAs used as investment accounts, as interest earned in TFSAs isn’t subject to taxation (see section below on account types).
Receiving dividends from a company generally indicates that this company is doing well and earning enough profits to distribute a portion to shareholders.
Canadian eligible dividends are taxed at a lower rate than interest income, so they’re tax efficient. Canadian non-eligible dividends (e.g., from a private corporation) are taxed at a higher rate than eligible dividends, while dividends paid by foreign companies are taxed the same as interest income.
When you sell an investment for a higher price than you bought it, or if investment funds distribute a capital gain to unitholders, that gain becomes “real” (instead of only a gain “on paper”) and is taxable. Fortunately, your realized capital gain is taxed at the most favourable rate because only half of this gain is taxable.
Return of capital
Sometimes an investment fund distributes cash that comes from a return of capital. Think of it as a partial refunding of your original investment. Since these distributions are not taxable when received, they represent a tax-efficient cash flow stream. When you sell your investment in the fund, any return of capital is accounted for and will either increase your capital gain or reduce your capital loss.
In addition to the type of investment income, the type of account also affects the tax you pay. For instance, income earned in registered accounts like a Registered Retirement Savings Plan (RRSP) or Tax-Free Savings Account (TFSA) is taxed more favourably than a non-registered investment account.
Income and gains/returns earned in an RRSP is tax deferred until you withdraw it, which is generally in retirement when your tax bracket is typically lower, resulting in less tax to pay. For TFSAs, since you make contributions using after-tax dollars, any income earned will never be taxed – regardless of income type.
Which account type makes sense for which kind of investment income?
Type of investment income
Best type of account, generally, for that source of income
Interest (and other income sources taxed like ordinary income)
Tax-deferred account (e.g., RRSP) or tax-sheltered account (e.g., TFSA)
Non-registered account for eligible dividends (which benefit from lower tax rates), or tax-deferred account for non-eligible dividends (which don’t get the benefit)
Return of capital
Non-registered account, as the cash flow received is not immediately subject to taxation
It’s important to remember that a well diversified portfolio designed for your unique goals and financial circumstances should come before tax considerations. Investment income comes in different forms, so consider the tax implications of the income you earn. After all, 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 portfolio manager.