Benjamin Franklin famously said that there are two certainties in this life: death and taxes. But just because taxes are a certainty, doesn’t mean the amount you pay is pre-ordained. With a bit of planning, and a bit of knowledge about how Canadian investments are taxed, you can help cut down on the amount of tax you pay, and keep more of that money for yourself. Here are a few things you need to know.
The usual annoying disclaimer applies here: I’m not a financial advisor, nor a tax expert, so you should talk to one if you have specific questions. One day, I’m going to get my certification just so I can stop writing that, mark my words… anyway, I digress. Onward!
Interest income is taxed like regular income.
Interest income refers to any money you earn from things like GICs, Bonds, and other things that pay interest. A decent rule of thumb is that, if you’re not buying ownership of something – like a company, property, or whatever – then chances are your investment is paying you interest income.
I hate interest income, because it’s the least tax-efficient form of income you can have. It’s taxed at your full marginal tax rate, compared to many other investments that are taxed at less than that. Let’s take a look at what some of those are.
Dividends are taxed less than interest.
Dividends are payments made by a company to its shareholders when it earns enough profit that there is money left over after it reinvests in its operations. I like these payments a lot better than interest income, because they’re taxed less, thanks to a couple of tax credits that reduce the amount of tax you pay.
For example, if you’re in the highest tax bracket and paying about 53% in taxes on your last dollar earned, $1,000 in interest income would cost you $530 in taxes. On the other hand, $1,000 in dividends would only cost you about $390, thanks to those handy credits I was talking about. That’s a huge difference!
Capital Gains are taxed even less than dividends.
One of my favourite (if it’s possible to have a favourite anything when you’re talking tax) types of tax to pay is capital gains tax. The reason is that capital gains – which happen when you own an asset that appreciates in value, like a house or stocks – are only taxed at half your marginal tax rate. In other words, if we go back to that $1,000 and call it a capital gain, you’d only pay $265 at the highest tax bracket, compared to $390 if it were a dividend and $530 if it were considered interest.
Now just because you own a house or stocks, that doesn’t mean you’ll be paying capital gains tax every year. Rather, you’ll only pay it when you sell your investment for more than you bought it for. So if you bought an investment property for $200,000 (not in this day and age, unfortunately), then sold it for $300,000, you’d have a $100,000 capital gain. You wouldn’t have to deal with that if you didn’t sell though!
So what do I do with all this knowledge?
Well, there are a few things, but I’m going to focus on the very basics for today’s post. For starters, if you’re not already maxing out your RRSP and TFSA contributions, start there. Money invested inside an RRSP or TFSA, regardless of what type of income it produces, grows tax-deferred or tax-free, which is amazing. Those are two of the best tools that we as Canadians have at our disposal when it comes to building wealth.
If you’re already maxing out your RRSP and TFSA, on the other hand, then you want to start talking a closer look at what investments you’re holding within those buckets, compared to the investments you hold outside of them.
In this case, the key is to put all of your most-taxed investments – that is, anything paying interest income – into your TFSA and RRSP first. If you’ve still got room after that, then add stuff that pays dividends. Last comes capital gains, and it’s really ok if these investments sit in a taxable account.
One thing to note: many investments make money in the form of both dividends and capital gains, with stocks being the most obvious example. In those cases, treat them somewhere in between pure dividend-paying investments and pure capital gains investments, since the amount of tax you pay falls somewhere in between.
By setting things up this way, you’ll ensure that you’re only paying tax on your most efficient investments, while protecting your less-efficient ones in sheltered accounts (your RRSP and TFSA). To sum up one more time why you should care about his: Over the year, this could literally put thousands of dollars more into your pocket instead of the government’s.
Wrapping it Up
Look, we all work hard for our money. It’s hard enough to bring home the bacon, let alone keep it on the table once it’s there. While this stuff may not be super-sexy, it’s the kind of knowledge that can help you keep your family well-fed for year and years to come. The less money you pay in taxes, the more stays in your account and the faster you can get to that retirement goal!
