Given the state of things these days, it’s becoming more apparent that we ought to focus more on the money that we get to keep after taxes. Majority of the public gloss over the fact that almost all of our expenditures are with after tax dollars. This is a fact and yes, it sucks lol.
You might think investing into the market is not technically an “expenditure” item, however on the balance sheet it is a cash outflow from your checking account into your investment accounts. You can think of it as “paying” into saving up for your eventual retirement.
We all hate to look at our paystubs due to the ridiculous taxes on there. What we get in our pockets are then told by the banks and such to “invest”. Since we’re investing with after tax dollars, shouldn’t we maximize its earning potential to account for the taxes that has been shaved off? Even then afterwards, we should pay attention to our investments so they don’t cause unnecessary taxable event(s) on our tax returns.
Let’s take a look at the four major investment incomes that we can earn and their tax treatments.
- Interest Income & Foreign-sourced Dividends
- 100% of this type of income is taxed at your marginal tax rate (MTR)
What type of investments generate interest income?
- bonds and GICs
- remember a bond is a debt security, when you “invest” into one, technically you are really just borrowing money to a company; not actually investing therefore the income gets no special tax treatment
- similarly, foreign source dividends are paid by foreign companies that do not help to contribute in creating jobs in Canada and the dividends paid from these foreign companies’ earnings do not pay Canadian corporate income tax or help the Canadian economy
- this is why there isn’t any tax advantages provided from the CRA
Here’s an example:
Scottie Barnes earns $1,000 in interest from his GIC, assuming he’s in a 40% MTR, how much taxes will he pay?
$1,000 x 40% = $400 tax payable
Out of the $1,000 Scottie made on his investment, he has to pay $400 in taxes to the government; this is the case for foreign-sourced dividends as well.
- Canadian-Sourced Dividends
As you may or may not have known, dividends are taxed twice. Thus the CRA have granted preferential tax treatment on this type of income. When a company has net after-tax earnings, the board of directors will decide if and how much they will share with the shareholders. This payment to the shareholders is called a dividend.
When a company (corporation) earns income, it must pay taxes on that income, then the company pays the dividends out of its after-tax income. When the dividend is received by the shareholder, the government taxes it as income again. Hence, the government provides a dividend tax credit to help offset some of this double taxation.
If your dividends are eligible you will be informed on your T-slips (don’t worry, you won’t need to figure it out).
How do we calculate how much taxes are owed from Canadian-source dividends paid?
we follow a simple 4-step process
G – gross up the eligible dividend by 38%
T – tax owed; the tax that’s payable on the grossed up amount at your MTR
C – credit; 15.02% of the grossed up amount
N – net tax payable; the difference between the tax you pay and the credit you receive
***the values 38% and 15.02% are both set by the CRA***
Here’s an example:
Johnny Davis owns shares in a Canadian corporation, Bell Media. He gets $1,000 in dividend payment. Assuming 40% MTR, how much tax needs to be paid?
G – $1,000 dividend grossed up by 38% = $1,380
T – $1,380 x 40% MTR = $552
C – credit $1,380 x 15.02% = $207.28
N – $552 – $207.28 = $344.72 net tax owing
As you can see, when Johnny boy receives $1,000 in dividends, he has to pay $344.72 in taxes to the government and pockets the rest; not a bad deal if you ask me!
Some of you keeners might have realized one thing, what if the dividends paid were in USD dollars but the company is Canadian? We still go through the 4 step process regardless of the currency of the dividends paid; as long as the company is Canadian. Also, regardless of the dividend being paid in cash or as stock options, the tax treatment remain the same.
However, from a financial planning perspective, we must be aware that receiving dividends will increase your net income which can lead to the following:
- reduction in benefits (such as medical claims)
- triggering of OAS (Old Age Security) claw back
- reduction of disqualification of GIS (Guaranteed Income Supplement)
- reduction in age credit
As you can now appreciate, by only focusing on how much your returns are in a specific investment is far from the whole overall picture of engineering a comfy retirement package.
- Capital Gains
We all have heard of the recent news regarding capital gains. Before everyone loses their hair over this, let’s go back to the basics.
Investing in businesses is good for the Canadian economy because it generates tax revenue for the government. As a result, the government gives you a special tax break on capital gains by taxing only half of your gain known as the inclusion rate.
Capital gains/losses on an investment are calculated as the proceeds received from selling an asset minus the adjusted cost base (ACB) of buying the asset initially.
Here’s an example:
Sally-Jo bought $800 worth of shares in an ETF. She let it sit and decided to sell today at the price of $1,800 on the market. Assuming 40% MTR, how much taxes does she have to pay?
capital gain = proceeds of the sale – ACB
capital gain = $1,800 – $800 (her initial purchase price)
capital gain = $1,000
$1,000 capital gain x 50% inclusion rate = $500 <– taxable capital gain
$500 x 40% MTR = $200 tax payable
Sally-Jo’s overall investment return is $1,000 but she only has to pay $200 in taxes. Of course, if she decides to not sell the asset then there won’t be any gains/losses realized. It’s important to address when to buy/sell but do not time the market as the great ones say.
- Return On Capital
This one is a bit tricky to understand. The easiest way to think of it is the investor is getting a portion of their initial investment back.
When an investment distributes a portion of the investor’s own invested capital, it is called a return on capital and this phenomenon is non-taxable. This makes sense because the investor is just getting back their own money from their initial investment (which was after tax dollars initially).
Here’s an example:
Jennifer buys shares in Google for $1,500 and over the years has received $1,000 as return on capital. Today she sells her Google shares for $1,800 assuming 40% MTR, how much will Jennifer pay in taxes?
First we need to calculate the capital gains:
$1,800 (proceeds of sale) – $500 (ACB = $1,500 – $1,000)
= $1,300 of capital gains
Taxable capital gains
= $1,300 / 2
= $650 taxable capital gain
Tax payable
= $650 x 40% MTR
= $260 tax payable
As you can see, Jennifer’s return on capital reduced her ACB, which resulted in a larger capital gain. Also, the $1,000 ROC has been deducted in the ACB; this makes sense as Jennifer is getting part of her money back so it shouldn’t be taxed again.
However, this larger capital gain will usually lead to more taxes, therefore as an investor, you should be mindful when selling off investments with ROC.
Bottom Line
From the above four types of investment incomes, hopefully you have gained an insight on what I’m trying to preach. At the end of the day, it’s really about what you get to keep rather than how much return you can make on an investment. You will find that sometimes it might be more advantageous to realized a capital loss or hold off from selling a stock.
A key point I’d like to point out, is that if we’re investing in a registered account such as RRSP, TFSA, RESP etc. none of this matters as registered accounts are either tax sheltered or deferred. The above is only of importance when you are investing in non-registered accounts.
Lastly, let me leave you with this, investing is very important to building wealth, but planning and taking account of all aspects of your financial wellbeing is more crucial to engineering a healthy fat retirement.
