In Canada, we have a progressive tax system which means individuals are taxed according to the level of their taxable income. As taxable income increases, we are taxed at a higher rate, up to each point. Each increment of taxable income that is taxed as a specific rate is referred to as a marginal tax bracket.
Tax rates vary by province and different tax rates apply to different types of income. Salaries and professional income, for example, are taxed at different rates than Canadian dividend income or capital gains.
Your Marginal Tax Rate
Your marginal tax rate is the rate applicable to the next dollar of taxable income you earn. Knowing your marginal tax rate is important for minimizing the tax you pay on additional income.
Understanding How Your Investment Income Is Taxed
Different types of income attract different rates of taxation. One of your considerations when buying investments should be the amount of taxes you will pay on income from these investments.
The types of income you could earn include regular income from business, employment, pension and retirement; and income from investments, including interest, rents, dividends, foreign income and capital gains.
Regular income and interest income are the highest taxed types of income in Canada. Interest income is earned from banks accounts and from fixed income investments, such as Canada savings bonds, guaranteed interest contracts (GIC’s) and government treasury bills (T-bills).
Dividends are distributions paid by corporations to their shareholders from after0tax earnings. You may also receive dividends from segregated fund contracts or mutual funs that you own if the funds own shares of corporations that pay dividends.
Canadian dividends generally attract a far lower level of taxation compared to interest income and salary earnings. However, because of the way dividend income is taxed—the gross up amount is reported on the tax return, it can be disadvantageous to Canadians 65 and older that qualify for valuable government benefits such as Old Age Security and the Age Credit. If the income reported on one’s tax return is too high, these benefits can be clawed back, or forfeited altogether.
Canadian dividends are broken down into both “eligible” and “non eligible” dividends.
Eligible dividends are taxed more favorably at the personal level and typically will be received from larger publicly traded corporations in Canada. Non-eligible dividends are taxed less favorably and generally would be received as a distribution of corporate income that has been taxed at lower corporate rates, such as income from a corporation entitled to the small business deduction.
Capital gains arise when you sell a capital asset for more than its purchase price. The increase in value is a capital gain and 50 percent of the gain (called taxable capital gain) is included in your taxable income.
There are two types of capital gains: realized and unrealized. An unrealized capital gain consists of the accrued gain on an asset before the asset is sold or deemed to be sold. A realized capital gain generally results when the asset is actually sold or deemed to be sold, as is the case on death.
Foreign income consists of income, such as dividends from foreign investments, whether owned directly or through a segregated fund contract or mutual fund. Foreign income receives no special tax break, making it undesirable as interest income in terms of the higher rate of tax that it attracts.
Interest income usually is taxable annually as earned, whether or not it’s actually received. Dividends are generally taxed when received. Capital gains, however, are taxable only when realized. This means that you can minimize your tax bill by rejecting speculative investment practices and investing with a long term buy and hold strategy.
Understanding the Taxation of some Common Assets
So far, we’ve discussed how individual assets are taxed, along with the taxation of certain types of income. Now let’s look at the taxation of specific types of assets that are owned in non-registered accounts.
The increase between your purchase price and the market value of your mutual fund units is taxed as a capital gain when the units are sold or deemed to be sold. Distributions from a mutual fund are taxed according to the nature of the distribution (dividends, interest, etc.). This distribution is taxable to you whether you receive the distribution in cash or reinvest it in additional units. If you reinvest this distribution to purchase additional units of the same fund, the amount of the reinvested distribution as added to your adjusted cost base (ACB) of the funds.
A common mistake for investors is forgetting to keep a record of these reinvested mutual fund distributions. The reinvested distributions are added to their ACB, thereby reducing the amount of any capital gain that arises when the fund is ultimately sold.
Market Traded Bonds and Bond Mutual Funds
Bond mutual funds and other bonds that are actively traded in the market are taxed according to the type of return they generate. Since these bond investments are market traded, their values can rise and fall according to economic conditions. Consequently, as they are bought and sold in your portfolio, capital gains or losses can result. Other income generated from these investments is taxed separately as interest.
Segregated Fund Contracts
Segregated fund contracts offer protection features only available through an insurance company including death benefit and maturity guarantees, income guarantees, potential creditor protection and the ability to bypass your estate.
From a tax perspective, a segregated fund contracts increases in value over its original purchase price is taxed as a capital gain when sold. Allocations received from segregated fund contracts are taxed according to the nature of allocation (dividends, interest, etc.). The amount of the allocation is added to your ACB and tracked by the insurance company. Furthermore, allocations cannot be paid in cash like mutual fund distributions.
The increase between your purchase price and the market value of your stock holdings is taxed as a capital gain when the stock is sold or deemed to be sold. Any dividends received from the stock are taxed at rates applicable to the Canadian or foreign dividends.
GICs and Canada Savings Bonds
Non-market traded fixed income investments, like GICs and Canada Savings Bonds, are not taxable on the principle amount. Only the interest earned on this investment is taxable.
Because we pay so much in tax, every precaution we can take to minimize tax counts!
Investment taxation is often overlooked but a very important are of personal financial planning. If you have any questions on this topic or would like a review of your current financial plan, please call 778-478-9759, or email [email protected]
This column is presented as a general source of information only and is not intended as a solicitation to buy or sell investments, or life insurance, and should not be taken as providing, investment, financial, legal, accounting or tax advice.