Taxation of your investments plays an important role in personal finance. In order to earn the highest return you can, you should reduce controllable costs, which includes taxes. In today’s episode, I’ll outline how various investments are taxed, and how you can use this information to make important investment decisions.

Different investments are taxed differently. Investments within TFSA’s are not taxed at any point (as long as you stay within the rules). RRSP contributions receive a tax deduction up front, don’t incur taxes along the way, but withdrawals are taxed fully as income. Once you’ve maxed out your tax sheltered accounts, the next option is to invest in a taxable investment account. This account also goes by the names non-registered account, taxable account, cash account, investment account and open account. Returns in non-registered accounts are taxed depending on their nature.

Investment returns come from 3 main sources.

The first is interest payments. These are regular payments from a bond, GIC, or savings account at a fixed percentage and interval. The second is through dividends payments. Dividends are distributions of after-tax profits of a corporation to its shareholders. They are not guaranteed and will depend on the profits of the firm. The third source of return is capital appreciation. Profits are kept within the company and reinvested in projects which drive future profits, and therefore drive the price of the corporation’s shares.

You can find out more about this in my videos: Investing in Stocks: Earning a return on Equities and Investing in Bonds: How Do I Make Money Buying Bonds.

Interest payments are taxed at the owner’s marginal tax rate. The same goes for dividends received from foreign companies. For example, suppose someone in Ontario earns a $50,000 salary per year. They receive $100 in interest over the year from their high interest savings account, and hold Microsoft shares in a taxable investment account. They received a dividend from Microsoft for $100 this year. Both the interest from their savings account and the dividend from Microsoft will incur taxes of $29.65, at the owner’s 29.65% marginal tax rate.

Dividends from Canadian corporations receive preferential tax treatment through a gross-up and tax credit mechanism. The rate of tax paid on dividends depends on your income. For example, say you own shares in RBC. In 2017, you received dividends worth $100 from your investment. At the $50,000 tax bracket, your tax would look like this:

Your $100 dividend is grossed up by 38%, so your dividends total $138 on your tax return. At a 20.05% federal tax rate, you’d pay twenty-eight dollars and twenty nine cents. In Ontario you’d owe twelve dollars and sixty-three cents at the 9.15% tax rate. But you get a tax credit of twenty seventy-three based on the 15.02% federal credit, and a 10% tax credit of thirteen eighty in Ontario. This means that in total you’d only pay six dollars and thirty-nine cents in tax on your $100 dividend.

Capital appreciation on a stock or bond is only taxed when the investor sells the stock or bond.

Selling a stock at a profit generates a capital gain. Capital gains are taxed at half your marginal tax rate. For example, the $50,000 salary earner sells their 50 Microsoft shares for $100 dollars, each share, resulting in proceeds of $5,000. They had purchased their Microsoft shares 3 years earlier, for $75 apiece. The capital gain on this sale is therefore $25 per share, or $1,250. Half of the capital gain will be taxed at the investor’s marginal rate. So $625 times 29.65% results in taxes of $185 on the $1,250 gain. Capital losses (in other words, selling a stock or bond at a loss) can be used to offset capital gains in the 3 previous tax years, or carried forward indefinitely.

Capital gains and dividends are better to hold in taxable accounts over interest securities due to their preferential tax treatment. When your taxable income reaches $91,831, or the 43.41% tax bracket, capital gains are more beneficial tax wise, whereas below that income, Canadian dividends are preferred. While it is important to understand the tax consequences of your investments, it is also important to make sure that the tax tail doesn’t wag the investment dog. You should first choose the appropriate investments to meet your goal, and then place them in your various investment accounts so that they are tax efficient, rather than simply finding the most tax efficient investments for your current tax situation, that may or may not allow you to achieve your long term goals.

Have you maxed out your RRSP and TFSA and are wondering what to do now? Let me know in the comments below.

Federal Ontario
Tax Rate 20.5% 9.15%
Dividend $100 $100
Eligible Dividend Gross-up $138 $138
Tax on Dividend $28.29 $12.63
Tax Credit % 15.02% 10%
Tax Credit $ -$20.73 -$13.80
Total Tax $7.56 -$1.17
Combined Federal & Provincial Tax $6.39