Most Canadians take advantage of tax sheltering within a Registered Retirement Savings Plan (RRSP) or through the tax-free benefits of a Tax-Free Savings Account (TFSA). However, outside of registered accounts, tax efficiency plays a key role in building wealth.
Income from your investments can come in various forms, the most common of which include interest, dividends and capital gains.
Each of these types of income are taxed differently by the Canada Revenue Agency. For example:
- Like wages, interest income typically earned on investments such as Guaranteed Investment Certificates (GICs) or savings deposit accounts is taxed at an individual’s highest marginal tax rate. This makes interest the least tax-efficient form of investment income.
- Dividends paid on stocks issued by eligible Canadian corporations receive more favourable tax treatment, since this type of income benefits from the federal dividend tax credit. In other words, dividend income is more tax-efficient than interest income. This means that investors in dividend-paying investments keep more of what they earn after taxes.
- Capital gains are triggered when you sell your investment for a higher price than your book value (also called adjusted cost base or ACB). Your book value is calculated by adding your total amount of contributions into a mutual fund, plus reinvested fund distributions, minus any withdrawals. Book value is used to determine if an investor is in a capital gain or loss position for tax purposes. Similar to dividend income, capital gains receive favourable tax treatment, since only half of a capital gain is taxed.
- Dividends and capital gains are typically earned on equity investments.
It's what you keep after tax that matters
Net after-tax cash flow on $1,000 investment income
For illustrative purposes only. Assumes a marginal tax rate of 26%. Please note that tax rates are unique to the circumstances of each individual and province they live in. Tax rates are subject to change. * Includes only the Federal Dividend Tax Credit. † Represents eligible Canadian dividends. Note: All figures are rounded to the nearest whole number.
After-tax returns illustrate your investment returns minus taxes. Simply put, if the one-year rate of return on an investment is 8% and an investor had a marginal tax rate of 26%, then the after-tax rate of return would be 5.9%.
Achieving tax efficiency within an investment portfolio is not just a strategy for people who need cash flow today. If your investment plan includes long-term goals, like a comfortable retirement, minimizing the amount of taxes you pay on your investments can have a tremendous impact on your portfolio over time. That is why building an effectively diversified portfolio — one that includes the appropriate mix of cash, fixed income and equities according to your investment objectives — is key to building wealth and accelerating growth over time. The types of investments you own and whether you hold them inside of or outside of registered plans (RRSPs and TFSAs) can have a bearing on the tax efficiency of your overall portfolio and, ultimately, on your ability to achieve your financial goals.
The following table provides a brief description of some of the different types of distributions that investors may receive from mutual funds and how each type is taxed.
What are the different types of distributions?
Here are descriptions of the different types of distributions you may receive from a mutual fund and how they are taxed.
|Type of distribution||Description||Tax Treatment|
|Interest||Earned on investments such as treasury bills, GICs and bonds||Fully taxable at the same marginal tax rate as ordinary income|
|Canadian dividends||Occurs when funds invest in shares of Canadian public corporations that pay dividends||Preferential tax treatment for individuals through dividend tax credits as either eligible or non-eligible dividends|
|Capital gains||Realized when an investment within the fund is sold for more than the adjusted cost based (ACB) of the investment||Preferential tax treatment as only 50% of a capital gain is taxable|
|Foreign non-business income||Earned when the fund receives dividends, interest or other types of distributions from non-Canadian investments||Fully taxable at the same marginal tax rate as ordinary income|
|Return of capital (ROC)||ROC is used to describe distributions in excess of a fund’s earnings (income, dividends and capital gains). For tax purposes, ROC represents a return of an investor’s own invested capital||Not taxable in the year received, but reduces the ACB of the fund, which generally results in a larger capital gain (or smaller capital loss) when the investment is sold|