Taxes and investment income: Which investments can reduce your tax bill?

You’ll receive interest income if you have:

• a savings account,
• a money market fund,
• a fixed income, or
• a bond component in your portfolio.
   

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.”

• buys dividend-generating stocks, and
• makes an annual distribution to unitholders like you.

You may generate a capital gain or loss if you sell:

• Mutual fund units, or
• Bonds that you own (before the term expires).
   

For example:

• If you bought shares in ABC Co. for $10 each and sold them for $20 each, you would have a $10-per-share profit. That is a capital gain.
• If you bought at $20 a share and sold at $10, you would have a loss of $10 per share. That is a capital loss.

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).

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:

• is likely in a lower tax bracket than you, and
• can use some of those education expenses to further reduce their tax bill.

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.

TFSA contributions are not deductible, and withdrawals are not taxed. Any investment income and growth is entirely tax-free.

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.

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:

• stock,
• bond or 
• mutual fund.

Then, it’s taxed at your marginal tax rate.

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:

• in a year when you have an offsetting loss, or
• when your taxable income is lower because you were out of work.

When you choose to take the gain becomes part of your tax strategy.

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.