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.
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.
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.
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 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.
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.
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.
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. 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.
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.
You want to make sure you are optimizing your returns, not losing them to the taxman.