Paying taxes is no fun. But if this was an especially lucrative year for your investments, you may owe even more taxes than usual.
To put it simply, if you invest in a non-registered (or taxable) account and you realized a 10% gain on your investments last year, you would have to pay taxes on these gains.
There are several different ways to earn money on your investments, and each comes with different tax rates. Not all investments or tax rates are created equal. So what’s the difference between interest, dividends, and capital gains taxes? And which of these are the most tax-friendly?
We at Claret are not tax experts, but we believe it’s important for our clients to have a fairly good idea of what’s going on with their investments. That includes taxes payable on those investments.
There are three main ways you can earn money on your investments: Interest, Dividends, and Capital Gains.
Taxation of interest income
Let’s begin where it hurts the most: Interest. Of these three ways, interest is where you will pay the most taxes. That’s because interest income is fully taxed at a person’s highest marginal tax rate.
Let’s use interest earned from bonds or even GICs, as an example. If you hold a 5% bond, this bond will pay you 5$ in interest every year. If you earn a salary of $100,000 per year, then your marginal tax rate is roughly 45%.
Forty-five percent of $5 is $2.25 cents, which means you will have to pay $2.25 cents in taxes. Tax-wise, this is the least efficient form of investment income, which is why you might choose to hold more money in your registered (non-taxable) accounts.
Dividends tax rates and tax credits
The second type is: Dividends. If you hold shares of one of the big six Canadian banks, you’re receiving dividends every quarter.
If that dividend were instead paid by a foreign company, like a company in the United States, it would be taxed at as ordinary income, and at a much higher rate.
Determining your dividends can seem complicated. To keep things simple, think about dividends as “eligible” and “non-eligible. Dividends are taxed at a lower rate than interest income, and the non-eligible dividend is taxed more than the eligible dividend, after adjusting for gross up and tax credit.
Capital gains taxes
Finally, we have capital gains. Out of these three, capital gains are taxed the least.
Here’s a simple example. Say you buy one share of a company for $10. Then you sell it for $15. You just made a capital gain of $5. Half of that gain is recognized as taxable income.
Now let’s revisit our $100,000 per year from earlier, with a marginal tax rate of about 45%. That 45% is applied to one half of your $5 capital gain. $5 divided by 2 is $2.50, and 45% of $2.50 is $1.13 cents. A silver lining with a loss instead of a gain is that it reduces your taxable capital gains.
Don’t forget that if you hold a Mutual Fund or an ETF (an exchange-traded fund), they can still pay you interest, dividends, capital gains, or a combination of those through the distributions. Mutual funds and ETFs are a basket of securities, so they can also pay you a return of capital.
Think of a return of capital like a capital gain. Remember when we bought a share at $10? Let’s imagine that his this time, you bought $10 worth of a mutual fund. Before you sold it at $15, the mutual fund returned $2 of capital back to you.
This reduces your cost from $10 to $8. That means when you sell at $15, you’ll have made a capital gain on $7. Half of it will be taxed 45%. So, 45% of $3.50 cents means you’re left with $1.57 cents.
Returns of capital can lower your cost to zero and sometimes, even lower in the negatives. Note that before it dips negative, or below zero, you only have to pay your capital gains when you sell your position. However, when it reaches negative $2 dollars, you will have to pay those $2 dollars as a capital gain right away in your next tax return, even if you don’t sell your position yet.
Foreign withholding taxes
Lastly, there’s foreign withholding taxes. If you are a Canadian resident, you are required to pay taxes on any income earned, anywhere in the world. This is why you might have seen the T1135 (or Foreign Income Verification Statement) in your tax documents to tell the CRA your foreign assets and foreign income.
As Canadian investors, the most common international investments are U.S. companies. There can be as much as 30% withholding tax on the interest or dividends earned in the U.S. by foreign individuals.
By doing so, the Internal Revenue Service (IRS), the American CRA equivalent, makes sure that applicable taxes are withheld before the income, net of withholding taxes, are paid to a foreigner. However, since Canada and the U.S. have a tax treaty, clients usually sign a form (such as the W-8BEN) to reduce the withholding tax to 0% – 15% on the interest and dividend, respectively.
On the other hand, if you do not provide a relevant tax residency form, such as the W-8BEN, the excess withholding tax (the extra 15% on dividends for example) would only be refunded by filing a US non-resident alien tax return, but the preparation of the return can cost more than the potential refund.
As a side note, RRSPs, but not TFSAs, are exempt from US withholding tax when you directly hold US stocks, bonds or some ETFs.