First, it is important to realize that investment income from a registered plan and that earned outside registered plans are treated differently from a tax standpoint.
Investments in registered plans
In registered plans (RRSPs, RRIFs, LIRAs), taxation is deferred until withdrawal. You therefore have no income tax to pay on the income that you earn before then. When you withdraw an amount, it is taxed at the same rate as your other interest income.
In the case of a tax-free savings account (TFSA), no income tax is payable on income earned (interest, dividends, capital gains) either while you hold it or when you withdraw from it.
Investments outside registered plans
Income from an investment outside registered plans is taxed in various ways at rates that vary according to their type.Interest income
This type of investment income is taxed at the highest rate. In addition, even if the interest is paid only upon maturity of the investment, it is taxable annually as long as the guaranteed interest rate is known. It is therefore preferable to put your interest income-generating investments in registered plans.Capital gain
Capital gain is the profit made upon the sale of an asset; 50% of the gain is taxable. On the other hand, if you have a capital loss, 50% of the amount is deductible. Thus, it makes more sense not to put investments giving rise to capital gains in registered plans, since the income tax will have less of an impact on returns. Moreover, if applicable, it is possible to apply capital losses against past or future capital gains.Dividends
Dividends are paid by a company to its shareholders in proportion to the shares each one owns. For a Canadian company, the dividends it distributes benefit from a special tax treatment. The dividend tax credit takes into account the fact that the company has already paid Canadian income tax on its profits. However, for dividends from a foreign company received by a Canadian, there is no dividend tax credit. A foreign country may require that income tax be withheld when dividends are paid, and if so, it is possible to benefit from a credit for foreign tax in Canada.A few additional clarifications regarding dividends!
- The tax treatment for Canadian dividends received by an investor requires that the dividend amount be multiplied by a gross-up rate to obtain the amount to include in the investor’s income and thereby claim the non-refundable dividend tax credit, thus reducing the income tax payable.
- If the dividends are reinvested, they are taxable in the year they are received and must be added, without applying the gross-up rate, to the calculation of the average cost, in the same way as when additional shares are purchased.
- There are two types of dividends: eligible and common. The type of dividends received is identified by the Canadian company that pays them and all information required to report the income is provided on the T5 and Relevé 3 tax slips.
Overview of tax rates
For more information regarding personal income tax rates, follow the links below.
Taxation: a key element in the allocation of your portfolio
Since not all investment income is taxed in the same way, it is important to take this into account in the allocation of your portfolio so that it is as efficient as possible from a tax standpoint. Of course, it must also be established according to your investment objectives and your investor profile.