Different types of investment income have varying tax implications which are important to consider in overall financial planning and minimizing income taxes. It is important to know how the various types of income are treated for tax purposes. The most common types of investment income are interest, dividends, and capital gains. Note that this is only applicable to non-registered investment accounts, as registered accounts such as Registered Retirement Savings Plans (RRSP), Registered Retirement Income Funds (RRIF), and Tax-Free Savings Accounts (TFSA) are not subject to annual income tax on interest, dividends or capital gains.
Interest income refers to the compensation an individual receives from loaning funds to another party. Interest income is earned most commonly on fixed income securities, such as bonds, mortgages, GIC’s, and alternative fixed income vehicles. Interest is taxed at your marginal tax rate without any preferential tax treatment and is taxed annually whether or not it has been received in cash or reinvested back into the investment.
An investor purchases a bond which pays 3% interest annually. If the investor bought the bond for $100, they can expect to earn $3 in interest every year until the bond matures and the principal is repaid. The investor must report the $3 of interest income on their income tax return which will be taxed at their personal marginal tax rate.
Since interest income is reported as regular income, it is the least favorable type of investment earnings in a non-registered account. Interest income, thus fixed income vehicles, are typically better suited to be held in registered accounts.
Dividend income is considered to be property income. A dividend is generally a distribution of after-tax corporate profit that has been divided among the corporation’s shareholders. The Canadian government gives preferential tax treatment to Canadian corporation dividends in the form of a dividend income gross up and dividend tax credit. The two main types of dividends from a Canadian company are categorized into 1) eligible, or 2) non-eligible dividends. Eligible dividends are dividends from a larger (typically public) company which has already paid a higher rate of corporate income tax. A non-eligible dividend is received from a smaller (typically private) company that has paid a lower rate of corporate income tax. Dividends from foreign corporations are not subject to any special tax treatments and are to be reported in Canadian dollars as regular income.
When you receive an eligible dividend, the personal income tax rate is lower than when you receive a non-eligible dividend due to the fact that the larger corporation has already paid a higher amount of corporate tax.
A shareholder of a Canadian Controlled Public Corporation is paid a dividend of $100. This income is considered to be an eligible dividend and is subject to the gross up and the tax credit. This dividend would be grossed up 38%, so you now have an income of $138. The dividend tax credit would be 15.02% of the grossed-up amount, equaling $20.73. Therefore, the shareholder would report a dividend income of $138, but would have their federal taxes owing reduced by $20.73.
The rationale for the gross up and tax credit is related to the fact that dividends are paid in after-tax corporate earnings. This tax treatment makes dividends a more tax efficient way to receive income than interest income. Tax is payable when the dividends are received.
Further, let’s discuss the after-tax considerations which is very important. Compare the after-tax effect of holding a bond which pays 3% interest compared to owning shares of the same company which pays a 3% dividend. For an individual in the 43% tax bracket, 3% in interest income will result in a return of 1.71% after-tax; compared to 3% dividend income results in a return of 1.9% after-tax. A difference of 0.19% per year. This is not considering any potential increase or decrease in the value of owning the shares or bonds.
Capital gains are realized on investments that appreciate in value from the time they are sold compared to the original cost. For example, if an investor bought a stock at $5 per share and sold them at $10 per share, they would have a capital gain of $5 per share. What makes capital gains different from other types of investment income is that you only are required to pay tax on 50% of the gain. Another desirable trait of capital gain income is that you do not have to pay tax until the investment is disposed of, giving the investor some control over when they trigger the gain and pay the tax.
Summary of How Various Types of Income are Taxed Personally Based on Marginal Rates of Taxable Income
As you can see, “Other Income” such as interest income and employment income is always taxed more heavily than dividends and capital gains. Further, capital gains are typically more tax favourable than dividends – depending on your level of income and the type of dividend.
The Bottom Line
Fixed income vehicles (interest income) are best suited to be held in registered accounts to avoid paying a higher rate of personal income tax. Equities and other vehicles which earn dividend and capital gain income are best suited to be held in non-registered accounts, with some exceptions. Maintaining the same overall portfolio allocation, while ensuring that your investments are held in the appropriate account considering the after-tax implications is called Asset Location.
This is a brief summary to help inform you how your investments are being taxed and the implications that different types of investment income can have on the amount of income tax you owe. As stewards, we always take into account the effect of income taxes on your portfolio and ensure that it is managed in a tax efficient manner. This after-tax approach is surprisingly rate with more investment/financial advisors.