Understanding how different investments are taxed can help investors decide where to put their money and how much tax they may have to pay.GETTY IMAGES
The securities investors choose, and the investment vehicles they hold them in, can lead to different tax outcomes.
“It’s important to know … for example, [that earning] a 5-per-cent interest rate is not the same as a 5-per-cent capital gain when it comes to taxation,” says Jason Heath, certified financial planner with Objective Financial Partners Inc., in Markham, Ont.
The tax treatment also depends on whether the money is in a registered account, such as a registered retirement savings plan (RRSP) or a tax-free savings account (TFSA), or a non-registered account. Understanding how different investments are taxed can help investors decide where to put their money and how much tax they may have to pay if the investment appreciates or they withdraw it.
Income versus dividends versus capital gains
Guaranteed investment certificates (GICs) are among the safest investments available, which is why so many Canadians buy them, especially when interest rates are higher.
What some investors overlook is the higher tax rate on the interest income, Mr. Heath says. GICs in non-registered accounts are taxed at an investor’s marginal rate, which is higher than the tax rate for capital gains and dividends from equities and bonds.
Capital gains – which are the profits realized on the sale of stocks, exchange-traded funds (ETFs), mutual funds, or real estate – are only taxed at 50 per cent.
For example, if you bought a stock for $1,000 and sold it for $1,500, you would be taxed on only $250, or half the gain. With bonds, you pay a capital gain if you sell the bond for a higher price than you paid for it, while interest payments from bonds are taxed as income at your marginal tax rate.
Dividends are taxed based on whether they’re eligible, which are those typically paid by publicly traded companies, or non-eligible, which are paid from income taxed at the lower small business tax rate. Eligible dividends are considered more tax-efficient because they benefit from the dividend tax credit, which is larger than the credit received by the lower small business rate.
Still, eligible dividend income is only tax-efficient to a point. While you receive a tax credit to account for taxes paid by the corporation issuing the dividend, which reduces your taxes on that income, the gross-up rule means the pre-tax dividend income counts toward net income on your return.
And that can reduce income-tested benefits such as Old Age Security (OAS), says MaryAnn Kokan-Nyhof, certified financial planner with IG Wealth Management in Winnipeg.
“I’ve met new clients drawing so much dividend income that the gross-up amount eliminates their OAS entirely,” she says.
The tax treatment also depends on other income and the province you live in, says Tannis Dawson, a high-net-worth planner at TD Wealth in Winnipeg.
“There’s quite a range of rates with Saskatchewan residents paying the lowest and Newfoundlanders paying the highest,” she says, adding that, in some provinces, such as Alberta and Ontario, individuals can earn up to $70,000 annually from dividends and pay no tax, as long as they have no other taxable income.
Registered or non-registered accounts
The taxation of investments, whether income, capital gains or dividends, also depends on where they’re being held. For example, investments in TFSAs grow tax-free, even when withdrawn (as long as you stay within contribution limits), while in an RRSP they grow tax-free, but tax is paid on the amount withdrawn.
It’s why Ms. Kokan-Nyhof says investors concerned about an OAS clawback may be better off adding more dividend-paying equities to their TFSA.
While it might make sense to hold higher-taxed investments in a registered account, Mr. Heath notes there are potential tax implications. For example, he says RRSP withdrawals are taxed like earned income, at your marginal tax rate.
It’s also possible to have “too much money in an RRSP,” Ms. Dawson adds, given the mandatory minimum withdrawals once it’s converted to a registered retirement income fund (RRIF). Depending on the size of the RRIF and other income, Canadians could end up in a higher tax bracket than when they were working.
The tax efficiency of dividends and capital gains doesn’t matter as much in retirement, she says, because money is already growing tax-sheltered in a registered retirement account and it is fully taxable as income when withdrawn.
Dividends from U.S. stocks are generally tax-exempt in an RRSP, making it the best account for these securities because investors otherwise must pay a 15-per-cent withholding tax, Mr. Heath says.
The exceptions are U.S. dividend income from Canadian-domiciled exchange-traded funds (ETFs) and mutual funds. “The withholding tax applies, but it’s kind of hidden,” he says, noting taxes are withheld before dividends are paid to a fund.
No rule of thumb says, “this investment must be in your RRSP,” Ms. Dawson adds, noting the decision depends on an investor’s goals, risk appetite and taxable situation.
For example, she says an RRSP is a better place for interest income because withdrawals are fully taxable, but that is only when investors are drawing retirement income. A TFSA is better for long-term growth assets such as stocks.
“But capital gains in a non-registered account aren’t a bad strategy either,” Ms. Dawson says.