Did you know that taxes on your investments are not uniform? Explore the world of taxes and investment incomes such as interest, dividends, and capital gains.
When you earn income over a certain limit, there is no escaping that you will have to pay taxes. In fact, tax evasion is a crime. However, while you cannot completely avoid paying taxes, there are several ways that you reduce the amount of taxes that you have to pay. One of the most popular ways of paying less taxes is through investing. That’s right. Investing not only helps you grow your wealth, but it can save you on taxes too! Did you know that tax efficiency can play a key role in growing your wealth? At the same time, it’s important to note that there are some taxes levied on the income earned from investments too. Confused? Need a better understanding of taxes and investments? Don’t worry, we’ve got your back. Let’s delve into the world of taxes of investments!
First things first, let’s cover the basics, so you have a firm grounding on the concepts upon which we can keep building.
What are taxes?
Taxes are a type of payment that is made to the government of any country by the income-earning citizens of the country. Taxes provide the government with funds for their various expenditures, without inflation. These expenses may include welfare projects for the citizens or even developing infrastructure such as roads, transport, public amenities, etc. Taxes are often seen as a scourge, especially when it feels like a large chunk of your income goes into paying them. However, there are many tax-saving mechanisms available such as Tax-free Savings Accounts or even a Registered Retirement Savings Plan that offer some form of tax-sheltering.
What are investments?
In the simplest terms, investments are any kind of asset or even item you acquire that is set to grant you an income or is bound to appreciate in its value. Unlike goods or services that you pay for and consume, an investment is acquired or purchased because of the returns (material or otherwise) that it will grant you in the future. In financial terms, investments could be in the form of real estate, cash deposits, stocks, bonds, shares, etc.
Now you know that taxes are amounts you pay when you earn an income. You also know that investments are assets that are meant to earn you an income. So, does that mean that there you will have to pay taxes on investments too? The answer - yes. The income you earn from investments is taxed as well. However, the Canadian Review Agency (CRA) levies different types of taxes on different types of income that you may earn from your investments. Not all incomes from investments are taxed equally. Thus, to be more tax-efficient or save taxes on the income you earn from your investments, it’s important to know just how each type of income is taxed. Let’s examine what this means in more detail:
Popular types of income earned from investments
There are different types of income that you can earn from your investments. However, we will focus on the three most popular types of income earned from investments. These are interest, dividends, and capital gains.
Interest:
Interest income is the amount you earn on an investment such as a savings deposits, treasury bills, various types of bonds, or Guaranteed Investment Certificates (GICs). The interest you earn on your investment depends on the posted interest rate. Higher interest rates will grant you access to a larger interest amount. On the other hand, if the interest rate is low, the amount of interest you will earn on your investment will be smaller. Interest income is generally seen as the most basic type of investment income.
Dividends:
Dividends are an investment income you earn when you own a company’s stocks or shares. When a company makes a profit, it pays out dividends to all its shareholders. It is important to understand that not all the profits a company or corporation makes is paid out as dividends. Some portion of it may be reinvested to grow the business. These decisions are made by the management of the company. While some companies prioritize growth, others may put paying out profits to shareholders as their main objective. Either way, whether you are earning a larger chunk of the profits or a smaller portion, the dividend income you earn from investing in the stock or share of a Canadian company or corporation is taxable.
Capital Gains:
Capital gains are the income you earn when you sell an investment for a higher price than you originally purchase price. The difference between the two prices is your capital gains income. Let us understand what capital gains means with an example. Suppose you purchased some real estate for $150,000. If conditions are favourable, the value of the real estate appreciates over the course of the next few years. If you then sell that same piece of real estate for $200,000, you will have earned capital gains of $50,000. Before you rejoice at this imaginary profit, know that some of this $50,000 you just earned will have to be paid as taxes. You will be required to pay taxes on your capital gains as that is considered taxable income.
Taxes on different types of incomes earned from investments
As mentioned earlier, there are different types of taxes levied on the incomes earned from different types of investments. We have also covered the different types of income you can earn from investments. Now, let us explore how these different types of investment incomes are taxed. Read on to discover how taxes are levied on each of the investment incomes discussed above, such as interest, dividends, and capital gains.
Taxes on interest income earned on investments
When you earn interest on investments such as savings deposits, Guaranteed Investment Certificates (GICs), treasury bills, or bonds it is treated in the same way as your regular salary or income. This means that the interest amount you earn is fully taxable. Not only that, but it will also be taxed at the highest marginal tax rate.
Taxes on dividend incomes earned on investments
Income that you earn from dividends paid out by an eligible Canadian company are treated in a more favourable manner than income earned as interest when it comes to taxes. This is because of a little something called Federal Dividend Tax Credit. This is a non-refundable tax credit that makes it possible for you to pay lower taxes on your dividend income. However, this type of tax credit is applicable only to eligible dividends. What makes a dividend eligible or ineligible? Well, to start with an eligible dividend is one that is “paid out by a Canadian resident corporation, received by a Canadian resident individual, and designated by a corporation as an eligible dividend under section 89(14) of the Income Tax Act.” Bear in mind that it is not enough for the corporation to merely be Canadian. They also need to have designated the dividends they pay out at ‘eligible’ or ‘other than eligible’. If they designate their dividends as eligible dividends, it means that they paid higher tax rates. In turn, you will receive a higher tax credit.
Taxes on capital gains
The taxes on capital gains may be the most favourable of them all. This is because only 50% of the income acquired as capital gains is taxable in Canada. That means you will only have to pay taxes on half the amount that you earned in the form of capital gains. The rate applicable on 50% of your capital gains will be the marginal tax rate. Borrowing our example from above, let us see how your capital gains on your real estate investment would be taxed. Since the capital gains in that case would be $50,000, you would have to pay taxes on only 50% of $50,000. That means you would only have to be pay taxes on $25,000. Of course, this is just a hypothetical example. In the real world, only a portion of this $25,000 would fall within the taxable bracket, making the amount you will be taxed on even lesser. However, no matter what the actual amount of your capital gains may be, according to Canadian law, you will only have to pay taxes on half the income earned as capital gains.
Strategies to Save on Taxes
As you can see, the different types of investment incomes are taxed in different ways, with some allowing more tax-saving benefits than others. Knowing about the kind of taxes you would have to pay on your investment incomes can help you make better decisions when it comes to making your investment strategy as tax efficient as possible. If you are aware of the advantages one type of investment income has over the others, in terms of taxes, you can also better determine just how much you should be investing in different investment options available to you.
When it comes to the best investment strategy and all the investment options you can explore, we’re more than happy to help you. Contact us and benefit from the expert advice of any of our investment advisors.
*Mutual funds and other securities are offered through Aviso Wealth, a division of Aviso Financial Inc. Financial planning services are available only from advisors who hold financial planning accreditation from applicable regulatory authorities. The information contained in this article was obtained from sources believed to be reliable; however, we cannot guarantee that it is accurate or complete and it should not be considered personal taxation advice. We are not tax advisors and we recommend that clients seek independent advice from a professional advisor on tax related matters.
