By: Kevin-Barry Henry, #1 Bestselling Author
Any Canadian who has filed a tax return knows that we pay a lot of taxes in our country. However, knowing how we’re taxed might be a good starting place to help us minimize the tax that we do have to pay.
In Canada, we have a tax system where individuals are taxed according to their taxable income. As your taxable income increases, you will be taxed at a higher rate, up to a certain point. Every increment of taxable income that is taxed a certain rate is what we call a marginal tax bracket.
Tax brackets vary by province. There are three different categories of income that will be taxed at different rates: Income, dividend and capital gains. Your salary from your employer for example is fully taxed at your marginal tax rate, but Canadian dividend income and capital gains (and losses) will receive preferential tax treatment.
Marginal Tax Rate
Your marginal tax rate is the tax rate that will be applied to the next dollar of taxable income that you earn. It is important to know your marginal tax rate to help minimize the tax you will have to pay on additional income. Here is a marginal tax rate table by province to help you out.
How Your Investment Income is Taxed
As previously mentioned, there are three different types of income and each one is taxed differently. When it come to making decisions on what type of investment you want to own, it is important to know how it will be taxed. The three types again are interest, dividends and capital gains and losses. There is a fourth category – foreign income – but today we will be focusing mainly on the “big three”.
Interest income will be fully taxable at your marginal rate, much like your salary from your employer. It is one of the highest taxed categories of income. Interest income can be earned from bank accounts, fixed-income investments like guaranteed interest certificates (GICs) and government treasury bills (T-Bills). Basically, any investment that pays a return in interest, will be taxed as interest income.
A dividend is a distribution paid by a corporation to the shareholders of the company from after-tax earnings. You can also receive dividend allocations or “distributions” from mutual funds, segregated fund contracts or exchange-traded funds (ETFs) that you have invested in.
When compared to interest income, dividend income will get preferential tax treatment through a complicated maneuver that is called the “gross-up and dividend tax-credit mechanism. The grossed-up (higher) amount will be included on your tax return but the tax you will pay is reduced by the dividend tax credit, which will also be higher.
Because the grossed-up amount is reported on your tax return, it can be a detriment to Canadians who qualify for government benefits such as the Old Age Security and the Age credit. Since the grossed-up amount is included on your tax return, it will also increase your income and if your reported income is too high, your benefits can be clawed back. You can learn more about the clawbacks in last week’s article by clicking here: WHAT IS THE OAS CLAWBACK?
Capital Gains occur when you sell an asset for more than you paid for it. What you paid for it is called the “adjusted cost base” (ACB). The increase in value is a capital gain. 50% of the capital gain is tax-free to you. The second 50% however is taxed as income (the same category as your salary) and will be taxed at your marginal tax rate.
For example, if you buy an investment for $20,000 and sell it for $30,000, congratulations, you have a capital gain of $10,000 ($30,000 – $20,000 = $10,000. The first 50% of your $10,000 gain is $5,000 and that is yours to keep. The second 50% however is taxable at your marginal rate. If, for example, your marginal rate was 40%, then you would owe 40% of $5,000 or $2,000 in capital gains tax. So, your $10,000 capital gain is now $8,000 after tax.
Because we pay so much tax, every precaution we can take to minimize our tax bill counts. Investment taxation is an often overlooked but very important area of personal tax planning.
This is by no means an exhaustive deep dive into investment taxation in Canada, but it is what I hope will be a helpful overview of why it is worth it to be at least aware of how the tax code will view your investment returns.
Sometimes – in most cases in fact – the initial investment return will look a lot better than the actual after-tax return will, but the banks might not tell you that when you pull out your cheque book.
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THIS ARTICLE IS PROVIDED AS A GENERAL SOURCE OF INFORMATION ONLY AND SHOULD NOT BE CONSIDERED TO BE PERSONAL INVESTMENT OR LEGAL ADVICE. READERS SHOULD CONSULT WITH THEIR FINANCIAL OR LEGAL ADVISOR TO ENSURE IT IS SUITABLE FOR THEIR CIRCUMSTANCES.