Welcome to week two of four in our June series Back to School: Investing Basics. Last week we clarified the difference between investment account types vs their actual holdings (click HERE if you missed it!)

This week we’re going to take a closer look at how investments make money and when you should expect to pay tax (because few things suck more than a surprise tax bill am I right?) 

There are many factors to consider when choosing an investment, but ask anyone what motivates them the most and you will get a version of the same answer: returns.  

Rate of return is the measure of how much income your investment earns, expressed as a percentage of capital invested. For example if you invest $10,000 at the start of the year and by the end of the year you have $10,500, you earned $500 in investment income.  Your rate of return for last year was 5%, because $500 is 5% of $10,000.  Pretty straightforward right? Here’s something you might not know though…not all investment income is equal. How your investment earns income (in other words, what is the source of the profit) matters because it will determine how much tax you’ll have to pay on said income. Let’s dig in. 

There are three main types of investment income: 

Interest 

Interest is money you earn in exchange for lending your money to someone else, either by putting it into a deposit account at your bank, using it to purchase term deposits such as GICs or Treasury bills, or by investing in a fund that contains term deposits or other debt instruments such as bonds.  

Interest is considered a form of income, which means it is fully taxable. If you have a savings account or non-registered investment that earns interest, you will have to declare this income on your tax return and pay income tax at your marginal rate. Your financial institution will issue you a tax slip confirming your earned interest income for the year so don’t worry, you don’t have to track it yourself. 

Capital Gains 

In the investing world, the term “capital” refers to the initial sum that you invest. If you then go an sell that investment for a profit, that profit is known as a capital gain. 

If you buy a stock, the amount you pay for it is your capital investment. If you then go and sell that stock for a profit, your capital gain is the difference between the amount you sold it for less the amount you originally paid, and that gain is taxable. 

The most obvious benefit of capital gains over interest income is that only a portion of capital gains are taxable. As of the time of this writing only 50% of capital gains are taxable, however the federal government recently announced that they plan to increase the inclusion rate to 66.67% on capital gains over $250,000 for individuals, and on all capital gains realized by corporations. 

Let’s look at an example: Lacy bought some investments last year and from those investments she earned $5,000 in interest income, and $5,000 in capital gains. Let’s assume Lacy’s marginal tax rate is 30%. Interest income is 100% taxable, so Lacy will pay $1,500 in income tax ($5,000 x 30%). Only 50% of capital gains are taxed, so even though Lacy earned equal amounts of interest income and capital gains, her tax liability on her capital gains will only be $750 (($5,000 x 50%)x30%). 

With investments, sometimes you can realize a capital gain before you sell it. For example if you invest in a fund, you’re buying a collection of securities that are actively managed by a financial institution. Those managers are tasked with buying and selling stocks within the fund in order to generate profits for investors. When a fund manager sells a fund asset for a profit, this results in a capital gain which then gets passed on to investors. 

Dividends

Another way investors can earn income from stocks is via dividends. Dividends are a distribution of profits by a corporation to its shareholders. The amount of the dividend is determined by the company’s board of directors, and typically distributed quarterly. Investors can either receive their dividends in cash or they might choose to reinvest them. 

There are three types of dividends an investor could receive: eligible, non-eligible, and foreign, and all of them are taxed differently. This is where things get a little complicated but I’ll try my best to simplify: 

Eligible dividends are those received from large Canadian corporations. Non-eligible dividends are those received from smaller Canadian corporations who qualify for the small business deduction. Both eligible and non-eligible dividends are subject to what’s called the “dividend gross-up and tax credit”, which is essentially a mechanism designed to prevent double taxation on behalf of the corporation paying the dividend and the investor who receives it. Without getting too in the weeds, the end result is a tax liability that is lower than interest income but not as low as capital gains (most of the time). 

To continue on with our earlier example, if Lacy had earned $5,000 in the form of eligible dividends, based on the current gross up and tax credit amounts, she would have paid roughly $1,035 in income tax (compared to $1,500 on interest income, and $750 from capital gains.) 

Foreign dividends are dividends received issued by corporations residing outside Canada. Foreign dividends do not receive a gross-up and tax credit and are therefore fully taxable (same as interest income). Foreign dividends can also sometimes be subject to a withholding tax by the corporation’s country of residence. This is true for dividends received from US corporations, which are subject to a 15% withholding tax. In most cases you can recover at least some of this withholding tax by claiming what’s called a foreign non-business tax credit. 

After Tax Rate of Return

As you can see the type of investment income you earn is going to have quite an impact on how much of your returns actually end up in your pocket. For this reason, simply calculating an investment’s rate of return doesn’t always tell us everything we need to know. We now understand that 5% in interest income will give us a different end result than 5% in capital gains, so how can we measure our bottom line? We need to calculate our after-tax rate of return, which is the rate of return you earn on your investments after income tax has been deducted. 

For Lacy, if her initial investment was $100,000, then $5,000 represents a 5% rate of return. Based on the tax rates we calculated earlier, her after-tax rates of return are as follows: 

Interest

 $5,000 – $1,500 = $3,500

$3,500 / $100,000 = 3.5% 

After-tax rate of return = 3.5%

Dividends

$5,000 – $1,035 = $3,965

$3,965 / $100,000 = 3.97%

After-tax rate of return = 3.97%

Capital Gains

$5,000 – $750 = $4,250

$4,250 / $100,000 = 4.25%

After-tax rate of return = 4.25%

The bottom line? The more tax efficient your investment, the less you’ll pay in income tax. The less you pay in income tax, the higher your after-tax rate of return. 

What about registered investments? 

If you invest in an RRSP, TFSA, or other registered investment vehicle you might be wondering why the taxation of investments hasn’t come up before. This is because registered investments offer their own unique tax savings opportunities – hence why we use them. 

Tax Free Savings Accounts, like the name suggests, are tax-free, meaning you don’t pay tax on any investment income you earn within the account. 

RRSPs are tax-deferred. When you contribute to an RRSP you get to deduct that contribution amount from your taxable income which results in you getting a tax refund (or at least a reduction in the amount of taxes you owe. You do not have to pay tax on the income your investment earns each year, however when you eventually take money out of your RRSP, the entire amount will be fully taxed as income. 

Have a question? Leave it in the comments or contact me HERE.