Managing Taxes on Your Investments

If you're new to investing or taxes, or have never done your own taxes, you may not know that different types of income are taxed at different rates. Your salary is taxed at your regular income rate (which is a progressive system in Canada--the first X dollars are taxed at a certain percentage, and the next Y dollars are taxed at a higher percentage, and so on). The tax rate on your last dollar (i.e. the highest tax level that you hit) is your marginal tax rate.

How does this relate to your investments? Investment income can be grouped into 3 basic categories:

• Interest
• Capital Gains
• Dividends

Interest is taxed at your marginal tax rate. Capital gains and dividends, on the other hand, have some advantages in that they are taxed at less than your marginal rate. TaxTips.ca has charts of this information, which varies by province. Here is the chart for Ontario and British Columbia.

Capital gains tax is calculated by taking half of the taxable amount, and then applying your marginal tax rate. In other words, capital gains are taxed at half the rate of interest income.

Dividends are a bit trickier since there is a tax credit involved, but as you can see from the chart on TaxTips.ca, they are taxed generally at the lowest rate.

Keep in mind that income from foreign sources is generally taxed as regular income. The type of income--interest, capital gains, or dividends--does not matter for foreign sources. You may want to check for tax treaties with other countries to see if there are exceptions in your case.

I won't go through the exact rates or methods of calculation since they change from time to time, but you can see that some income is tax advantaged, and some (interest and foreign) is not. For example, suppose you could earn 3% interest income in a high interest savings account, or earn 3% dividend yield on a stock (both in a taxable account). You will get to keep more of your earnings from dividends than from the interest income. It is important to keep in mind that it doesn't really matter how much you earn on your investments. What matters is how much you keep.

For those of you who have all of your investments sheltered in an RRSP (or TFSA), this discussion does not really matter--all of your earnings are tax-free (and able to compound tax-free). If, however, you have your investments split between tax sheltered accounts and taxable accounts, you can maximize the money you keep by strategically placing certain types of investments in the RRSP, and leaving the rest in your taxable account. We'll look at an example of this tomorrow.