APRIL 22, 2024
By Chad Fraser and Sun Life Staff
Taxes are pain for just about everyone except maybe accountants. But they’re a fact of life.
When it comes to investment income, how much tax you pay depends on:
- your personal situation and
- how you structure your investment portfolio
To help, we’ll answer some questions about how and when you pay tax on your investments.
What are types of investment income and how do they work?
A basic investment portfolio can generate three types of income:
| Income type | How does it work? |
|---|---|
| 1. Interest income | You’ll receive interest income if you have:
For example, a five-year Government of Canada bond may have a “coupon” of 2.25%. This means for every $1,000 invested, you’ll receive $22.50 in interest each year. If you hold your bond component in a mutual fund trust, you’ll receive annual “distributions.” |
| 2. Dividend income | If you buy shares in publicly traded companies, you may receive dividends. This is a company’s way of sharing profits with its shareholders. You’ll receive a certain amount per share quarterly, semi-annually or annually. Likewise, you can receive dividend income from a mutual fund that:
|
| 3. Capital gains or losses | You may generate a capital gain or loss if you sell:
For example:
|
Need help understanding how your investment income is taxed?
How are investments taxed?
Each source of investment income is subject to a different tax treatment. However, how that affects your overall tax bill depends on how you hold those investments.
How are investments in registered accounts taxed?
If you hold investments in a registered account, any investment growth inside your account will not be taxed.
The tax treatment for your contributions and withdrawals will be different for each account:
| Account type | Tax treatment |
|---|---|
| Registered retirement savings plans (RRSP) | You get a tax deduction for your contribution. But when you withdraw money, you’ll pay taxes on the entire withdrawal at your marginal tax rate.* Because RRSPs are retirement savings vehicles, you likely won’t begin taking money from your account until you retire. (After all, there are some hidden costs to early RRSP withdrawals). So, presumably by retirement your income will be lower than it was during your working years. That means you may be in a lower marginal tax bracket. * Marginal tax rate is the rate of tax you would pay on an additional dollar of taxable income. |
| Registered education savings plans (RESP) | You don’t get to deduct your plan contributions, so withdrawals of those contributions are not taxed. You’ll pay tax on withdrawals of any investment growth. However, the child who uses the money for school fees will pay the tax at their marginal rate. That person:
If the withdrawal isn’t used for the child’s education, it’s taxed to the subscriber (the plan owner) at their marginal rate plus a 20% additional tax. You can avoid tax at your marginal rate and the 20% tax if you transfer the money to your RRSP. Remember, you must have enough RRSP contributing room to do this. |
| Tax-free savings accounts (TFSA) | TFSA contributions are not deductible, and withdrawals are not taxed. Any investment income and growth is entirely tax-free. |
How are investments in non-registered accounts taxed?
If investment income goes into a non-registered account, the tax treatment is entirely different. Interest income is 100% taxed. It doesn’t matter whether the interest is paid to you or reinvested in the account. If your account earns interest during the year, you pay tax on the interest.
| Type of investment income | Tax treatment |
|---|---|
| Dividends from corporations | You pay tax on dividends from foreign corporations as ordinary income, just like interest. But dividends from Canadian corporations receive better tax treatment. Why? Because companies pay dividends from their after-tax income. So, to tax that income again in your hands would be double taxation. This is something the Income Tax Act (ITA) tries to avoid. Instead, the ITA requires you to “gross up” the amount of dividend income you report by a specified percentage. This brings it back to approximately what it would have been before the corporation paid tax on it. Then the tax you pay on that dividend is offset by a tax credit. It sounds complicated. But in short, you pay a lower rate of tax on dividend income from Canadian sources than you do on interest income. |
| Capital gains | The most favourable tax treatment goes to capital gains. You’re required to include only half of that gain in your income in the year you sell your:
For example, let’s go back to our ABC Co. scenario. You sold the shares, for which you paid $10 a share, for $20 a share, making a $10 profit. Your income increases by only 50% of that gain, or $5. Another advantage for capital gains is that they are under your control to a certain extent. You can decide when you want to sell the asset and take the gain. For example, you could take the gain:
When mutual fund managers buy and sell investments at the fund level, however, they create capital gains and losses. You receive these as one of the unitholders of the mutual fund. |
How do these tax differences affect your investment strategy?
They won’t affect your overall asset allocation strategy. You’ll still have the same percentage of your investments in bonds, dividend stocks and equities held to produce capital gains.
Who can help you better understand the tax treatment of different sources of income?
What followed is a simplified picture. Anything to do with taxes and investing needs to be part of a larger plan that considers:
- your income needs,
- your investment time horizon and
- when you want to withdraw your money.
Understanding the tax treatment of your sources of income is a great topic for discussion with your advisor or accountant.
- If you don’t have an advisor, find a Sun Life advisor to work with.
Definition of terms:
- A unitholder is an investor who owns one or more units in an investment trust. A unit is equivalent to a share, or piece of interest.
- If a trust becomes a Mutual Fund Trust (MFT) within 90 days after the end of its first taxation year, it may make an election with the Canada Revenue Agency (CRA) to be treated as such from the beginning of that taxation year.
- A distribution can mean many things, most commonly when:
- a mutual fund distributes capital gains, dividends, or interest income to fund owners;
- a publicly traded company distributes interest or returns capital to shareholders; or
- a retirement account owner takes distributions in the form of taxable income.
This article is meant to provide general information only. Sun Life Assurance Company of Canada does not provide legal, accounting, taxation, or other professional advice. Please seek advice from a qualified professional, including a thorough examination of your specific legal, accounting and tax situation.