This post was updated on April 10, 2013
Non-registered investment accounts have no special “tax status” the way registered accounts, such as RRSPs or TFSAs, do. All investments held in these accounts are subject to tax, but not all investment income is taxed in the same way or at the same rates. Some investment income attracts less tax than others. This creates opportunities to minimize your overall taxes by using certain types of accounts to hold specific asset classes.
Your investment activities will generate income that falls into one of two categories:
- Income from property, which includes interest, dividends, rent and royalties
- Capital gains and losses, which are realized when you dispose of capital property (such as stocks, bonds or real estate) for more or less than what you paid when you acquired it
Rental income is calculated as gross rent less operating costs and capital cost allowance (CCA), which is depreciation expense for tax purposes and may not be used to create a rental loss. Rental income and interest income are taxed at full rates and are the least tax-efficient sources of investment income.
Dividends, which are distributions of profits by companies to their shareholders, are subject to favorable tax treatment through a “gross up” and tax credit mechanism. Eligible dividends, including most dividends from Canadian public corporations and certain dividends from private corporations, are “grossed up” to 138% of the cash dividend (in 2012). A tax credit of approximately 15.02% of the grossed up dividend (in 2012) is then applied to reduce federal and possibly provincial taxes payable. Most dividends from private corporations are also subject to this gross up and tax credit mechanism, but the gross up rate is 25% and the tax credit is 13.3% of the grossed up dividend.
Capital gains are also subject to favourable tax treatment. When there is an actual or “deemed” disposition of capital property for tax purposes, a capital gain or loss is realized, but only 50% of that amount is included in income as a taxable capital gain or allowable capital loss. It is important to keep track of the adjusted cost base (ACB) of capital property as certain amounts must be added to or subtracted from the original cost. Furthermore, selling expenses can generally be deducted when calculating the amount of the capital gain or loss.
If you are in the second highest tax bracket in Ontario, with 2012 taxable income between $132,406 and $500,000, the marginal tax rate you will pay on additional income from the following sources is as follows:
- Eligible dividends – 29.54%
- Non-eligible dividends – 32.57%
- Capital gains – 23.20%
- Interest, rental and other income – 46.41%
(including business and employment income)
Certain basic strategies emerge as a result of these differences. To minimize overall taxes, hold interest-bearing investments such as bonds, Guaranteed Investment Certificates (GICs) or Certificates of Deposits (CDs) inside a registered account like an RRSP or a TFSA – you will not pay tax on the interest. Hold stocks in non-registered accounts – although you will pay tax, dividends and capital gains are taxed at much lower rates than interest income.