If you're new to investing, one of the first questions you're likely to ask is, "Do I need to pay taxes on investment income?"
The short answer is, yes. However, how much you'll pay depends on various factors, such as where you live, your marginal tax rate (ex. the additional amount of tax paid for every additional dollar earned as income) and what types of investments you're holding. There are also ways to reduce taxes on income from investments if you plan accordingly.
Canadian tax brackets
Before you start trying to figure out how much investment income is taxable, it’s important to understand Canadian tax brackets. Canada has a graduate income tax system. People with a lower income pay a lower tax rate then people with a higher income.
It's also worth noting that there are two layers of income tax in Canada: federal and provincial. The total income you make and where you reside will determine your tax bracket.
One common misconception is that if you fall into a higher tax bracket, you'll pay a flat rate of taxes for your entire income. That's not the case since a graduate income tax system means you're taxed at a higher tax rate on additional dollars earned in the next tax bracket.
How are investments taxed in Canada?
Taxes on investment income in Canada will vary depending on what products you hold. The key is knowing what type of distributions you're receiving from your investments as this will determine the type of taxes you pay.
When purchasing products, such as bonds, guaranteed investment certificates (GICs), or treasury bills, you earn interest. This income is fully taxable and gets added to your overall income. The amount of your tax obligation will depend on your marginal tax rate.
Dividends are paid by corporations to their shareholders. Dividend can also be earned through investing in mutual funds. While dividend income is taxable, tax credits are available for both eligible and non-eligible dividends that can reduce your tax burden. Generally speaking, eligible dividends come from companies taxed at the general corporate tax rates, such as publicly traded companies. Non-eligible dividends typically come from companies taxed at lower corporate rates.
Foreign interest and dividends
Any income earned from a foreign source, which includes interest and dividends, is fully taxable at your marginal tax rate as regular income. However, if you paid foreign taxes on this income, you may be able to claim a foreign tax credit.
Generally, if you purchased investment products, such as stocks, and they had gone up in value when you sold them, you will have realized a capital gain and 50% of that gain is subject to tax. For example, let's say stocks you purchased increased in value by $5,000 when you disposed of them. You'd only have to pay taxes on $2,500, which gets added to your taxable income.
How to reduce taxable income with investments
Here are some ways you can look to reduce your overall tax burden.
Invest within your Tax-Free Savings Account
Your Tax-Free Savings Account (TFSA) can be used for a variety of different savings goals. You can purchase many different investment products within your TFSA, which includes stocks, bonds, mutual funds, GICs, and more, as long as the products are qualified investments for TFSA purposes.
All capital gains, interest income, and dividends earned within your TFSA can be withdrawn tax free.
Contribute to your Registered Retirement Savings Plan
Your Registered Retirement Savings Plan (RRSP) is another investment option that offers you a tax benefit, but also helps you save systematically and prepare for retirement and other financial needs. Depending on the contribution room available, you can reduce your taxable income in the year by the amount you contribute to your RRSP. This is one way to deferred taxes payable to the future.
Additionally, you only get taxed when you withdraw from your RRSP and this would be taxed as regular income. Many people are likely to withdraw from their RRSP when they're in their retirement years, when they expect their marginal tax rate will be lower.
There are also a few specific exemptions where you may not have to pay taxes on capital gains. The most common scenario is where you sell your home, that is considered to be your principal residence. However, this does not apply to investment properties as the exemption only applies to your primary residence. Learn more about how this works here.
There's also the lifetime capital gains exemption, which currently sits at $913,630 for 2022.* This exemption was created for people who are making a profit when selling a small business, fishing property, or farm.
Ask for advice about your taxes
Regardless of what you invest in, having an optimal tax strategy is a good idea. The best strategy needs to be tailored to your financial plan. Talk with your financial advisor or your tax advisor to determine what’s the best way to set up your portfolio for maximum tax efficiency. Every dollar you save can be put toward your financial goals.