Investing is about putting your money to work so you can reach your goals – whether saving for a down payment on your first home, your children’s post-secondary education or your retirement. But not all investment income is taxed equally, and over time, income tax can take a significant bite out of investment returns. It’s worth doing some planning to ensure you maximize your after-tax returns.
When you own bonds, you earn interest income, which is fully taxed, just like any salary, rental or business income you may earn. When you own stocks, you may earn dividends. Dividends are subject to a special gross-up and tax credit mechanism, which reduces the effective tax you pay.
If you sell any stocks you own, you may also realize a gain or loss – the difference between what you pay for a stock and what you sell it for, less any transaction costs. If the difference is positive, you have a capital gain; if it’s negative you have a capital loss. Only 50% of capital gains are subject to tax, providing significant tax savings. (Similarly, only 50% of capital losses can be used to offset other capital gains.)
In Ontario, the 2014 and 2015 top marginal tax rates on investment income (taxable income over $220,000) are as follows. Note the significant differences:
The tax you pay on investment income also depends on where you hold your investments. Consider that non-registered investment accounts have no special tax status. Any investment income earned is subject to tax. Investments held in registered accounts, on the other hand, are not subject to tax while they remain in the account, so your investment can compound and grow tax-free. This can have a significant impact over time, and can help you reach your goals sooner than if your investments were held in a non-registered account.
Take advantage of the registered accounts that align with your goals. Save for retirement with a registered retirement savings plan (RRSP), save for your child’s (or grandchild’s) university or college education with a registered education savings plan (RESP), or save for someone with a disability using a registered disability savings plan (RDSP). You can use a tax-free savings account (TFSA) to save for almost any goal, due to its flexibility: a vacation, a car or a down payment on a home.
Regardless of which registered account you are using, be sure to read the fine print. Specific rules apply regarding how much money you can put into each of these accounts, whether the amount you put in is tax-deductible and whether and when amounts you take out are taxable.
An investment rule of thumb is to place bonds in registered accounts, where they will not be subject to tax, and stocks in non-registered accounts, since the income they earn already enjoys tax advantages. However, these decisions ought to be made in the context of your overall investment strategy.