Taxation of Investment Income
An Introduction to Tax Planning – Part 4
You think of yourself and your spouse along with your two children as an average family. Like me you are a resident of London, Ontario. Between the two of you, you earn about $80,000 per year or about $40,000 each, which is about typical for a household in London, according to Statistics Canada. When you got married, you decided that you preferred to rent your home rather than scrimp and save for a down payment and make large mortgage payments for the next 25 years. Instead, you decided to invest.
Without a mortgage, you found that you had more than enough to not only fully fund RRSPs and TFSAs but also to put enough money in an RESP account for your children so that you could attract the maximum annual grant. You took the next step and opened a non-registered account at a discount brokerage, which meant you had to start paying attention to the taxation of the income inside that account.
You hold in the account a mix of Exchange-Traded Funds (ETFs) the holdings of which consist of stock from companies in Canada, the United States and the rest of the world. You also hold some Guaranteed Investment Certificates (GICs) to provide a bit of stability and generate some income, because you know that stocks tend to move up and down quite a bit in the short term.
In the new year, you receive a number of T slips, T5s, T3s and even a T5008. You see a figure in one of the T slips that talks about Interest from Canadian sources. Another set of three boxes talks about dividends: Actual amount of eligible dividends, Taxable amount of eligible dividends and Dividend tax credit for eligible dividends.
Because you often travel to the US, you had decided to invest directly in some US dollar denominated, US domiciled ETFs. The income from these sources also generated a T slip but different boxes were used: Foreign income and Foreign tax paid.
Finally, you received a T5008 which showed that you had sold one of your investments last year. You had bought an individual stock last year but had decided to sell it in favour of using ETFs. You note in particular two boxes with dollar figures in them: Cost or book value and Proceeds of disposition or settlement amount.
Taxation of Interest Income
If your taxable income was under $43,906 in Ontario in 2019 your combined marginal tax rate is: 15% federal + 5.05% provincial = 20.05%. In the illustration above, you earned $100 in interest income. Your tax on the $100 is therefore $20.05. The net amount left to you is $100 – $20.05 = $79.95.
Taxation of Dividend Income
Dividends are a strange animal in Canada. Eligible dividends from Canadian corporations are paid out of after-tax profits. To approximate the pre-tax value of the dividend, the Canada Revenue Agency (CRA) “grosses up” the amount of the dividend you received by 38 percent Tax is thus calculated on the grossed-up figure, $138, rather than the amount you actually received, $100. However, the dividend tax credit comes along to even things out, and act as incentive to invest in eligible Canadian corporations.
On an eligible dividend of $100 you are taxed (federally and provincially) at 20.05% on $138. Tax owing is $27.67. The after-tax net amount to you at this point is $100 – $27.67 = $72.33. However, you receive a federal dividend tax credit of $20.73, which reduces your tax to $6.94. The new net amount to you is $93.06. Adding in the Ontario dividend tax credit, which is 10% of the grossed-up amount, or $13.80, and the after-tax value of your dividend is actually greater than the $100 you received, $106.86. Putting it all together, the figure is $100 – $27.67 + $20.73 + $13.80 = $106.86.
Taxation of Foreign Dividends
Only Canadian dividends are subject to the gross-up and dividend tax credit rules. Foreign dividends are taxed the same as interest. Depending on the treaty with the country that is the source of the income, there may be different percentages withheld from your dividends. Dividends from US-domiciled companies incur a 15 percent withholding tax. For the purposes of this post, I am assuming that the conversion to Canadian dollars from US dollars worked out to exactly $100 in Canadian funds.
Taxation of Capital Gains
Capital gains are currently taxed at an “Inclusion Rate” of 50 percent of the amount you actually received in capital gains. In the components of the T5008 that I showed above, you bought 100 shares of ABC Inc. for $25.90 per share + $10.00 commission for a total Adjusted Cost Base (ACB) of $2600. At the end of November, you sold those 100 shares for $27.10 per share – $10.00 commission for proceeds of $2700. This gave you a capital gain of $100. If this were taxed as interest, you would pay 20.05% on the entire $100, which is $20.05. However, because the inclusion rate is 50%, you only need to pay tax on half the gain, $50. Therefore, the tax owing is $10.03.
Summary of Taxation of Investment Income (Excluding Foreign Income)
How do I Use Different Tax Rates to My Advantage?
Depending on your personal financial circumstances, it may make sense to emphasize one kind of income over another in your investment portfolio. In the taxable, non-registered portion, it is clearly an advantage to earn income via dividends or capital gains rather than interest. However, these sources of income are tied to the stock market, which, we have been reminded again over these last several weeks, can swing up and down in value rather dramatically. Imagine you have $100,000 invested in a Canadian equity ETF. In the course of the past year, you received $3,000 in dividends. Let’s suppose, though, that in the last month, the value of that ETF dropped by $30,000.
Or, let’s suppose that you bought an ETF primarily as an opportunity for growth, that is, big capital gains, rather than dividends. Until mid-February of 2020, it was doing just fine. It had gained 20 percent since you had bought it a year earlier. Then it proceeded to drop 35 percent in the space of a month. If you were to sell it now, you would be claiming a capital loss instead of a capital gain.
Maybe some low returning but steady sources of interest income aren’t so bad.
Some investment advisors argue that for the sake of tax efficiency, you should put all your interest earning investments in your RRSP. Why? Because when you withdraw from your RRSP (or RRIF), it will be taxed at the same rate as interest income. By contrast, it seems tax-inefficient to hold equities in your RRSP as the tax advantages of dividends and capital gains are essentially lost.
However, interest-bearing investments grow slowly. If you are investing for the long term, twenty or thirty years or more, holding assets with the potential for higher growth (i.e., equities) inside the RRSP makes a lot of sense because they are entirely tax-sheltered while inside the account.
Having said that, almost every kind of investment has trade offs. In the last few weeks, some of the assets in my own accounts have shown losses. They are worth less than what I paid for them. Inside a registered account I have no opportunity to claim the loss. In a non-registered account, however, I can realize the loss by selling those positions and use the proceeds to buy something else. When I do my taxes in 2021 for the 2020 tax year, I can match up the capital losses against any realized capital gains in order to reduce my overall taxes. If my losses turn out to be greater than my gains in 2020, I can carry forward the loss into future years. This option is not available in RRSPs, TFSAs or other registered plans.
In my next post I will conclude our series on taxation by considering charitable donations.
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Disclaimer: This blog post is intended for general information and discussion purposes only. It should not be relied upon for investment, insurance, accounting or legal decisions.