When it comes to building wealth, one of the most important factors to consider is your income tax burden. Income taxes take a bite out of all your investment returns, and failing to minimize them can cost you hundreds of thousands of dollars over your investing lifetime.
Investment income is taxed more favorably than income in Canada. This means you pay more income tax per dollar on salary or working income than you do on investment income. It’s almost like rich people who earn most of their income from passive investments and not working salaries made the rules!
Do I get taxed on investments?
You pay income tax on investment income. Investment income consists of interest, dividends, and capital gains. Each type of investment income is taxed differently, which is why it’s so confusing! Furthermore, exactly how much income tax you pay on your investments depends on your marginal tax rate.
Here’s a summary of how your investment income is taxed in Canada:
- Interest income is taxed at your marginal rate
- Dividend income is grossed up by 38%, then a 15% tax credit is applied, and the remainder is taxed at your marginal rate
- Half of your capital gains are taxed at your marginal rate
You can minimize income taxes on your investment income by choosing tax-sheltered accounts like the TFSA and RRSP, and choosing to invest in the stock market instead of earning interest in a savings account.
How much tax do you pay on investments?
How much tax you pay investments depends on the type of investment income, the type of account that holds your investments, and your personal marginal tax rate. Thankfully, you can typically optimize at least two if not all three!
Holding interest-paying investments in unregistered accounts as a high-income earner is the least favorable tax position. Holding growth stocks in tax-sheltered accounts as a low- or middle-income earner is the most favorable tax position.
TFSA investment income tax
For the most part, the Tax-Free Savings Account (TFSA) is completely tax-free. You do not pay income taxes on any investment income earned in this account, which is why it’s hands-down the best investment vehicle available to Canadians.
There is only one exception where your investment income is not tax-free in the TFSA: foreign dividends.
Foreign dividends in the TFSA are subject to a withholding tax. For US dividends, this is 15% or 30%. It’s 30% right off the bat, but you can reduce it to 15% based on US-Canada treaty agreements by filling out a W-8 BEN form and submitting it to your brokerage.
Many people choose not to hold US dividend paying stocks in their TFSA in order to avoid this withholding tax. However, you may miss out on huge capital gains on US stocks by doing this.
Think seriously about whether avoiding a 15% income tax hit on a 1% dividend is really worth missing out on 20% or 30% (or more) in capital gains on a US stock!
Your US capital gains in your TFSA are always tax free, and TFSA withdrawals are never taxed.
These tax rules for the TFSA apply to Canadian citizens only. If you are a dual US-Canadian citizen, the TFSA is not the great tax shelter it is for Canadians. You will have to pay income taxes to the IRS for your investment income earned in your TFSA.
RRSP investment income tax
Your Registered Retirement Savings Plan (RRSP) investments are tax-deferred, not tax-free. This means you don’t pay tax on them each year, but you will pay income taxes when you make withdrawals from the account in retirement.
Foreign dividends in the RRSP are not subject to a withholding tax. You receive the full dividend without any amount taken off by the IRS! This makes it more favorable to hold US dividend-paying stocks in your RRSP than your TFSA, if you are focusing on dividend income only.
Tax on non-registered investments in Canada
If you hold investments outside of the TFSA and RRSP, all your investment income is subject to income tax. However, each type of investment income is taxed differently.
How interest income is taxed in Canada
Income interest in Canada is taxed at the investors marginal rate. This makes interest the most expensive investment income you can earn because it’s treated just like income.
Unlike dividend or capital gains income, 100% of interest income is taxed in Canada. If you already thought your high-interest savings account interest rate was underwhelming, this should really drive the point home.
If you have a personal marginal income tax rate of 25%, your interest income will be taxed at 25%.
How dividends are taxed in Canada
Dividends from a Canadian public corporation are grossed up 38%, then a tax credit of 15% is applied to the gross upped amount. The remainder is taxed at your marginal rate.
For example, if you receive $100 in dividends from a Canadian stock, the amount is grossed up to $138. This is the amount your report as your dividend income. If your marginal tax rate is 25%, then your taxes are calculated as $34.50. However, you receive a dividend tax credit of just over 15%, or $20.70. When you subtract the dividend tax credit from the calculated income taxes, you end up with only $13.77 owing in come tax.
$100 in dividends earned x 1.38 = $138 dividend income
$138 x 0.25 = $34.50 calculated income taxes
$138 x 0.150198 = $20.73 dividend tax credit
$34.50 – $20.73 = $13.77 income tax owing
At a marginal income tax rate of 25%, you income tax rate on dividends is only 13.8%.
Dividends are taxed more highly than capital gains, but less so than interest income. Dividends are a great passive income source in your investment portfolio because they are more reliable and predictable than capital gains.
How capital gains are taxed in Canada
Capital gains are taxed favorably in Canada. You only pay income tax on 50% of your capital gains on investments. This means the remaining 50% of your capital gains are completely tax free!
For example, if you buy a stock for $2,000 and it grows to $3,000 and then you sell it, you have made $1,000 in capital gains. Only half of your capital gains, $500, are subject to income tax at your marginal rate. If you marginal income tax rate is 25%, then you will pay $125 in income tax on those $500 of taxable capital gains. The remaining $500 are completely tax free!
$1000 capital gains earned x 0.5 = $500 taxable income taxes
$500 x 0.25 = $125 calculated income taxes
At a marginal income tax rate of 25%, your effective income tax rate on capital gains is only 12.5%. This makes capital gains the lowest taxed investment income compared to interest and dividends. However, capital gains income is unpredictable and not guaranteed.
How cryptocurrency is taxed in Canada
Cryptocurrency has been an incredible investment the past few years, and many are wondering how much they owe for their investments come tax time. Good news: your cryptocurrency gains are only taxed if you sell your cryptocurrency.
If you’re still holding, you don’t owe any tax. Furthermore, cryptocurrency profits are only subject to capital gains income tax.
If you buy $5,000 of Bitcoin and it increased to $7,000, you have $2,000 of capital gains. Only half of that is taxable, so you will pay income taxes on $1,000 at your marginal income tax rate.
How real estate gains are taxed
The real estate market in Canada is crazy, so many people are turning a profit on their homes. The surprising news: there is no capital gains tax for your primary residence. If you have lived in your home the entire time you owned it, any capital gain is completely tax-free!
However, other real estate like a vacation, rental or other investment properties are subject to income taxes if you sell for a profit. These are considered “capital property” the same as stocks, which means they are subject to the same capital gains tax rules. You will pay income taxes on 50% of the capital gains of an investment property.
How to reduce income taxes on your investments
If you’re worried about income taxes on your investments in Canada, here are a few ways to reduce your income tax burden.
Invest in tax-sheltered accounts
The easiest and best way to avoid income taxes is to invest in tax-sheltered accounts like the TFSA and RRSP. You should do everything you can to max out these accounts before you start investing in unregistered accountS!
Invest in stocks and real estate
If you’re serious about investing, you should be doing so in stocks, cryptocurrency, and real estate. Don’t leave your cash sitting in a savings account! Not only are interest rates underwhelming right now, that interest is fully taxable at your marginal rate.
In order to minimize your income taxes, choose higher-yielding investments like stocks that pay dividends and grow by capital gains. Not only will these likely outpace your interest income, they will be taxed lower too!
Focus on capital gains
Many young people are lured by dividends, and it’s no mystery why. Steady, reliable passive income is a dream of any investor. But capital gains are not only taxed more favorably than dividends, they tend to be larger as well. For this reason you should choose investments more for growth than income, particularly when you’re young.