Written by Joe Snyder
Friday, July 17th, 2015
Different investments provide different types of income. Some income is passive, such as interest you earn in a savings account or distribution income you receive from mutual fund investments. Some income you earn is based on your own actions, such as buying a market-based investment at one price and selling it later at a higher (or lower) price.
As an individual investor it’s important for you to understand how different types of income are taxed because it will help you decide what account type is best for certain types of investments.
Different types of income
A common type of income is interest. You can earn interest by having money in a savings account or GIC, or you can earn interest by holding investments like mutual funds that invest in securities like bonds.
All of the interest you earn is taxed at your marginal tax rate [personal income] just like employment income. So what that means is that if your marginal tax rate is 30%, and if you earn $100 in interest, you’ll pay $30 in tax on that, leaving you with $70 earned in after-tax dollars. Interest income is the highest taxed of all types of investment income, so it makes sense to hold interest-bearing investments in tax-free or tax-deferred accounts
- Capital Gains
Another common type of income is capital gains. Capital gains can be earned in a couple of ways: 1) by receiving distributions from investments like mutual funds that themselves have capital gains. This capital gain income is passed through to the unitholders of those mutual funds. 2) By selling investments like mutual funds that you’ve made money on – i.e., you bought at say $10/unit and sold at $11/unit.
This would generate a capital gain of $1/unit. As an investor, you’re taxed on 50% of that capital gain. So if you made $100 in capital gains income, you’re taxed on 50%, or in this case $50. If your marginal tax rate was again 30%, it means that you’ll pay 30% of $50, or $15, in tax on that income, leaving you with $85 earned in after-tax dollars. As you can see, capital gains income is much more tax-efficient than interest income.
The last type of income we’ll discuss is dividends. You can earn Canadian dividend income by holding individual securities like stocks that pay distributions directly. You can also earn dividend income by holding investments like mutual funds that invest in companies that pay dividends. In both cases, dividend income is passive income, meaning that you didn’t have to initiate a transaction in order to receive it. All you had to do was own the security.
There are multiple factors that determine….your income, which province you live in, Dividends are taxed in a different and slightly more complicated way than either interest or capital gains. To recap, all of the interest you earn is taxed, but only half of your capital gains are taxed. Dividends, however, are taxed based on a number of factors that make it very specific to each individual investor. Here’s what I mean: dividends can be either “eligible” or non-eligible, or they can be foreign dividends. All three types are taxed differently. Two other factors that affect how dividends are taxed are #1, how much income you earn, and #2, which province you live in. Dividends benefit from a Federal Tax Credit, but also a Provincial Tax Credit, which has varying rates depending on your province. Basically, with dividends, there’s a “gross-up” factor to account for the tax that the company paying you the dividend already paid, and then various tax credits, which reduce how much you’re taxed. So as you can probably tell, it’s tough to generalize when it comes to tax implications of dividends.
In all cases, dividends are taxed more efficiently (i.e., less) than interest income, and in some cases, might even be taxed more favourably than capital gains. Often, they’re taxed somewhere between what you’re taxed on interest and what you’re taxed on capital gains.
Because interest is the highest taxed type of investment income, ideally it makes sense to hold interest-bearing investments in tax-free or tax-deferred accounts, such as TFSAs and RSPs. And if you have a good-sized portfolio of investments that are not held in registered accounts like TFSAs and RSPs, you’ll benefit more from the tax treatment of dividends and capital gains than interest income.