Taxes And Your Investment Income
Now that the tax deadline has come and gone, it’s a good idea to review your return to identify any missed opportunities and changes you may be able to make this year.
In particular, you should look at your investments to make sure they are still meeting your needs in a tax efficient manner.
Taxes and Investment Income
CRA does not make it easy for us. The tax due on investment earnings can be a challenge to calculate without tax software due to variables such as type of income, type of accounts, province of residence, and foreign sources and their tax treaties.
Related: Why tax free savings accounts are still misunderstood
Non-registered investment accounts have no special tax status the way registered accounts do. All income from investments held in a non-registered account is subject to tax but not all investment income is taxed the same way and at the same rates.
Moreover, tax-sheltered plans have their own tax rules when it comes to certain types of investments.
Here’s a quick review of taxation on various types of investments.
Interest income
Interest income is 100% taxed as regular income at your highest marginal tax rate. Sources are savings accounts, GICs and term deposits, CSBs and bonds.
You must also claim accrued interest such as from compound interest GICs and CSBs, and strip bonds, even though you can’t spend it yet.
Related: How to calculate capital gains and adjusted cost base (ACB)
There are no tax breaks, which is why financial advisers recommend holding these vehicles in your registered accounts – RRSP, RRIF, RESP, and TFSA’s.
Canadian Dividends
Many investors hold shares in publicly traded Canadian corporations in their non-registered accounts in order to benefit from the special tax credit on eligible dividends. 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.
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.
Related: Income splitting 101: Tips on keeping in the family
In addition, each province has a different tax rate for dividend income ranging from, for example, 9.6% in Alberta to 19.22% in Quebec, for the same total taxable income.
Capital Gains
If you sell your profitable shares from a non-registered account, 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.
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.
Related: When you need cash from your investments
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.
U.S. Dividends
Large U.S. corporations pay very attractive dividends and are particularly sought after by investors wanting income. Check out their after-tax value first, if not using a RRSP or RRIF.
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 applies to TFSA’s as well (so, in this case they are not really tax free).
Related: 8 retirement mistakes to avoid
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 NYSE. 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. Don’t invest in your RRSP, RRIF or TFSA.
Conclusion
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 another time.
Related: Leave a legacy before the will is read
You want to make sure you are optimizing your returns, not losing them to the taxman.
Great summary Marie!
Mark
Thanks, Mark.
Simple Rules to Live By:
TFSA: Canadian Stocks, Bonds, and Funds
RRSP: US Stocks, Bonds, and Funds
Cash Accounts: Foreign Stocks and Canadian based foreign funds.
@TJ Machado: Good general way to sum it up.
@Boomer and @TJ Machado : Thanks for the investment tax summaries.
I continue to be confused by this advice. TJ Machado’s summary is great – & I am looking for a simple summary for which TD e-series Funds to put in which accounts. By ‘Cash Accounts’ do you mean Non-Registered Investment accounts?
Apparently, Index funds are taxed in a slightly different way than ETFs. Most of the blogosphere advice refers to taxation & ETFs, to continue my confusion.
A summary of where to put e-Series Index funds would be greatly appreciated. I’m stalled by the confusing advice.
I’m not aware of taxation differences between Index Funds and ETFs. However, applying my advice to the TD e-series funds, here’s what I would do, assuming an all equity passive index portfolio:
TFSA: TD Canadian Index
RRSP: TD US Index
Non Registered Account: TD European, Japanese, or International
Hope that helps!
Thank you. Much appreciated.
Your confusion inspired me to write a blog post. Hope it helps: http://tjmachado.wordpress.com/2014/06/05/tax-efficiency-of-different-etf-configurations/
Yes, there are differences, index funds and ETFs are different legal entities and do things differently.
I am new to ETF investing and it was easy to google and read about it online. Depending on what you are after and your goals, income now, etc. one or the other may suit you better.
An index fund will result in capitals gains (hopefully not losses) when you sell; ETFs will distribute income each year, so you will be subject to tax on that income that year, instead of waiting until you sell.
Do you have a link where this is explained? The way you describe this, Index Funds do not need to distribute their investment income but rather re-invest the entire proceeds with no tax consequences to the investor.
Whether they be paid out in cash or re-invested, distributions are taxable on non-reg accts. It doesn`t matter whether its from an individual security, index fund or actively managed fund distributions are taxable.
http://www.moneysense.ca/columns/tax-efficient-investing-with-etfs
Yes, that is my understanding as well but Barbara seems to think otherwise.
It is so important for younger Canadians to start early and maximize their RRSP’s, TFSA’s, RESP’s etc. tax free, tax deferred accounts.
They also need to have non-registered money and depending on their risk tolerance and their taxable incomes, dividend income and capital gains will leave more money in their pockets.
Life insurance is also very important for younger families and others that have some dependent or dependents.
My closest friends are more conservative than us and are basing their long term rate at 4.00% putting away $11,000 in TFSA’s and $14,000 in RRSP’s annually.
The annual refunds of $4,500 are invested in non-registered accounts in GIC’s, term deposits, savings accounts.
They have $800,000 in term life insurance and $4,000 in tax free monthly disability coverage.
Everyone must be comfortable and able to sleep at night.
Reducing income taxes in non-registered accounts is important but not if that is your only focus.
Good summary. A couple things to add, most people don’t realize that since May 1, 2006 the donation of publicly traded securities to a registered charity results in zero capital gains (before 2006 the gains were taxed). If someone hasn’t donated in the past they could take advantage of the charitable donation super credit.
Also, the capital gain on a principal residence with a deemed disposition (ie. Converting it into a rental) can be sheltered even after it is converted but the formula basically gives the owner 4 years of shelter, and after that it is taxable
The capital gains tax free status of a primary residence in Canada is a great to keep taxes at bay but many Canadians lose sight how much it really costs to own and maintain a primary residence.
I have seen many many articles stating anywhere from 2.00% to 2.50% total annual costs, expenses, property taxes to own and maintain a house, condo.
They also use anywhere from 4.00% to 5.00% annual increases for these.
Taking an average 2.25% annual total cost, a $500,000 house would cost $11,250 a year today but using an average 4.50% annual increase for property taxes, utilities, home insurance, maintenance and repairs or condo fees etc., this means in 25 years when the maximum mortgage period a house is paid for, it will cost $33,811 per year.
Yes, it is capital gains tax free but there are many other factors, costs, taxes, fees etc. to consider instead of buying a big house or condo you don’t really need to live in.
A simple example, for every $100,000 extra in primary residence that is bought and not needed to live in, it will cost about $97,451 in just total costs.
Then the mortgage interest is about $41,972 over 25 years. If all this money was invested on a monthly basis and earned a 5.00% annual rate or return, you would have $469,320 in 25 years.
If you use a TFSA, it will be all income tax free but using RRSP’s could be as much as $650,000 but full income taxable.
People really need to be careful about how much house or condo they really need as this will impact their financial and retirement future in 25, 30 plus years.
Imagine the Canadians that are now buying $700,000 to $900,000 homes and $450,000 to $550,000 condos.
They will likely lose millions by the time they retire.
You are also assuming the housing market has a return of 0% there. We may or may not be in a housing bubble but over the past number of years the gain in the value of houses has been greater than the cost of borrowing. You need to consider many other variables when making that bold of a statement. What if one of those $900000 homes sells for 1.2 million when the owner retires. That alone could create quite a nice income stream…
I think your comments concerning capital gains is not correct.
Capital LOSSES can be carried back against capital gains from the three previous years – or – carried forward indefiitely against future capital gains.
Peter, you are correct that you can claim capital losses against capital gains up to 3 years back but this does not apply to a primary residence in Canada.
If you start renting part of your primary residence then that portion is not considered a primary residence anymore and is an investment property which then the above comments you made could apply.
This is true about capital gains and losses for non-registered investment accounts only as well.
I wish this was something I had to worry about! After buying a house it just all goes towards maxing out my TFSA again.
I would love to know what is the most efficient place to hold funds for small business owners with an operating company and a holding company.
I always wonder if I should dividend myself first then fund the TFSAs or just dividend it to the HoldCo tax free and invest it there as a non-reg account.
Kevin
So, all of us climbed into the small van and off we went.