November is Financial Literacy Month in Canada! Created by the Financial Consumer Agency of Canada (FCAC), the goal of this initiative is to educate Canadians on the importance of having the skills and knowledge to make the best financial decisions for their needs.
As the COVID-19 pandemic continues to impact the market, it is crucial now, more than ever, for Canadians to understand their finances. It is especially important for Canadian investors to be educated and make informed decisions.
In honour of the 10th anniversary of Financial Literacy Month, our team put together a guide for investors on understanding the taxation of investments.
Taxation of Investments
When you invest, it is important to be educated about the taxation of your investments. How your investments are taxed depends on the account in which you hold your investments and the type of investment income you earned.
Investments held in a registered account such as a Registered Retirement Savings Plan (RRSP) or a Tax Free Savings Account (TFSA) are taxed differently than those held in an unregistered account. Considered tax efficient, any income earned by investments is given “tax-deferred” or “tax-sheltered” status by the government.
Registered Retirement Savings Plan (RRSP)
For Canadians, investing in an RRSP is not only a great way to plan for retirement, but also to save on taxes. With an RRSP, you essentially defer paying taxes until a more tax-effective time – when you are retired. By the time of retirement, your income will likely be much smaller, thus your marginal tax rate will be much lower than it is now. This is especially beneficial for those in a higher income bracket as the larger your income is, the larger your marginal tax rate will be. Since income earned on your RRSP continues to compound tax-free, these additional funds can significantly amplify your portfolio returns over time.
Tax Free Savings Account (TFSA)
Similar to an RRSP, investments in a TFSA can grow without being taxed, but you do not receive a tax refund from your contributions. When you eventually withdraw your money, you do not have to pay income taxes as this money is “tax free.” TFSAs also have more flexibility as when you withdraw your funds, the amount is automatically added to your contribution limit for next year. But when you withdraw funds from an RRSP, your contribution room is gone (with a few exceptions).
Unlike registered accounts, non-registered investments accounts are fully taxable, but not all investment income is taxed in the same way or at the same rates. Some investment income attracts less tax than others, which creates opportunities to minimize your overall taxes. Non-registered accounts also have no contribution or withdrawal limits and can also be a good alternative option for investors who have already maxed out their contributions in an RRSP or TFSA.
As an investor, you will be taxed on:
- Interest Income
- Dividend Income
- Capital Gains and Losses
Interest may be earned from a bank account, a bond, or a mutual fund that holds interest-paying investments. Interest income is fully taxed; $1 of interest is $1 of income, meaning you pay tax on 100% of any income you earn. The rate you pay depends on your marginal tax rate.
A dividend is a reward given to shareholders who have invested in a company’s equity, usually originating from the company’s net profits. A dividend is considered a more favourable tax treatment than interest income as the dividend income you receive has already been taxed by the company.
Capital Gains and Losses
A capital gain is when you sell an investment for more than you paid for it, whereas a capital loss is when you sell an investment for less than you paid. The tax benefits of a capital gain or loss is that you only pay tax on 50% of your net gains. The other advantage is that you don’t have to pay the tax until the asset is sold.
Not all investments are taxed the same, so determining your best approach for investing can feel like a balancing act. While it is important for investors to be educated on the taxation of their investments, it is crucial to remember that portfolio managers will make the best tax-efficient decisions for their client’s needs.
If you would like to talk to a portfolio manager to discuss the best strategies for tax optimizing your investment portfolio, contact us today