Tax
Canadians are well acquainted with the concept of taxation. Like money you earn from a job, income you earn from investing is taxable, however, investments are not all taxed the same. I will note that many Canadians will be able to keep all of their investments within a tax shelter (discussed in the next chapters), and won’t have to worry about the taxes in this chapter.
Interest income, like from a savings account, GIC, or bond is fully taxed, which means that you pay tax on the income from the interest at your full marginal rate [22].
To encourage people to take some risks with their money – which is important for investments in business and the functioning of the economy – the government doesn’t tax gains from investments in stocks as much as they do safe investments.
Capital gains, what happens when you buy something and sell it for more, are only taxed at half the rate of regular income. You also don’t pay any capital gains tax until you actually sell [23] your shares, so if you’re a long-term holder of a stock (or index fund that holds stocks) you can put off having to pay any tax for a long time. If you have any capital losses they count against your capital gains, so you only pay tax on your net gain. If you end up with a net loss for the year, you can carry it forward to count against future capital gains, or even revise your tax returns for up to three years in the past and apply the losses.
Dividends are paid out from the earnings of a company to shareholders. The company has already paid tax on those earnings, so a tax credit is provided to the investor to account for the double taxation. The formula is a little complex, but the end result is that dividends are one of the most tax-efficient forms of regular income you'll find. An important caveat to that is that dividends generate income that gets taxed every year, whereas capital gains can be deferred. Also, if you have any income-tested government benefits such as the Guaranteed Income Supplement, then dividends can be undesirable because a greater amount is added to the income figure used in the test for eligibility. Called the dividend “gross-up” it’s a strange concept, but your tax software will handle all the calculations for you. Briefly, it’s as though the government pretends that you made all the money the corporation did to pay out the dividend in the first place, then gives you a tax credit to make up for the taxes the corporation paid.
If you own a mutual fund, the fund company or your brokerage will send you a form for income taxes (called a T3) in the spring of each year, making it easy to report your interest and dividend income. They may also report some capital gains on that form, which you must claim. These capital gains however come from the individual stocks within the fund being bought and sold. You still need to keep track of what you paid for the fund, and then what you eventually sell it for so that you can report the overall capital gains/losses from owning the fund. This will be covered in more detail in the Record Keeping section.
Return-of-capital is the last type of payment you may receive from an investment. This will eventually count as a capital gain, except you get the payment now. You will pay the tax later because return-of-capital reduces your average cost – for example, if you paid $5 per share for a company or mutual fund, and received $1 in return-of-capital, well in tax terms that’s just your own money coming back to you. So now you have $1 in cash, and a share that now has a cost of $4. If you sell at $5, you have a $1 taxable capital gain. It’s a little cumbersome to track, as you must record it yourself each year until you sell the investment (you will get a tax slip – a T3 – from your brokerage detailing the return of capital for any investments).
This is all assuming that you are keeping your investments in a regular taxable account (also known as “non-registered”). To encourage long-term savings the government also has several registered accounts that can reduce the taxes on investing and also the bookkeeping required. The next three sections will detail the most commonly used registered accounts: the TFSA, RRSP, and RESP. Many Canadians will be able to keep all of their investments in their registered accounts.
One important thing to remember for all these accounts is that you put investments (or cash) inside them, you don’t “buy an RRSP”. They’re baskets, not fruits. You can hold pretty much the whole range of investments you would hold outside these accounts: cash, GICs, bonds, stocks, and mutual funds made up of combinations of the above.
Footnotes:
22: There are common misunderstandings of how tax brackets work – they can be confusing. The tax rate is just applied on the "marginal" dollars in that bracket. It is not possible to make more money pre-tax and end up with less after-tax from a raise or investment moving you "up a tax bracket" – only that last extra bit is taxed at the higher rate. For more, see Advanced Tax.
23: There is something called a deemed disposition where you could have to pay capital gains tax even without selling. The most common case would be if you owned something in a regular account, then moved it into a registered account like an RRSP – even though you didn’t actually sell, it did leave your taxable account.