Here is a post on the taxation rules for various common savings vehicles.
Before we delve deep into taxation rules for earnings from savings, let’s start with some basic understanding of taxation on ordinary income.
As I mentioned in TFSA 101, all sources of income above the basic personal amount is taxable. The most common source of income is your ordinary income, which is subject to both federal and provincial income taxes. Ordinary income includes income from your employer, your tips, and your money earned as a freelancer. Of course, as a self-employed individual such as a freelancer, you are running your small business, so you are eligible for various business expense deductions. Possible deductions include work-space-in-the-home if you have an actual office at work, legal fees related to your business, etc. This means that as a small business owner, you will not have to pay income tax on every single dollar you earn. You will only need to pay tax on the portion after your eligible deductions.
The next most common item that people typically get taxed on is income coming from various savings vehicle.
This is the main topic of this article. Remember all the T3 and T5 forms you get from your banks and financial institutions in the first quarter of the year? These are the forms that indicate how much tax you have to pay on your interests, dividends and capital gains.
However, the T3s and the T5s you get in the mail do not include detailed calculations for how the financial institutions arrived at the numbers. I thought it’d be worthwhile and educational to take some time today to walk you guys through the calculations for taxes.
Example: John, $50,000 taxable income a year, Ontario resident
Let me introduce you to John, who earns $50,000 taxable income a year and is a resident of Ontario. According to the income tax rules in 2020, he has to pay 15% on the first $48,535, and then 20.5% on the remaining portion to the federal government. This means that his federal tax is $48,535 x 15% + ($50,000 – $48,535) x 20.5% = $7,581. On top of that, he will have to pay provincial tax, which is 5.05% on the first $44,740, and 9.15% on the next $44,742. This means that his provincial tax is $44,740 x 5.05% + ($50,000 – $44,740) x 9.15% = $2,741. In total, John has to pay $7,581 + $2,741 = $10,322 in income tax.
Let us see how much tax John will have to pay if he earns $100 from various savings vehicles, including a savings account, stocks that earn Canadian eligible dividends, and stocks that appreciate.
Tax on $100 in interest income
Let’s start with interest, which is taxed at your marginal tax rate. What does this mean? You may ask. Well, this means that the CRA treats your interest earning as ordinary income, and so it is subject to the same rules as the next dollar you earn from your employer.
There is no special rules for interest. The CRA will just add the $100 to the taxable income John earns from his regular employer, and treat it as if he earned $50,100 taxable income in 2020. As a result, that $100 is subject to 20.5% federal tax, plus 9.15% provincial tax. John will therefore have to pay $100 x 20.5% + $100 x 9.15% = $29.65 tax for the $100 interest he earned. That’s quite a bit of tax on not so much interest! But there isn’t really a way that you can avoid it unless you park it in a TFSA, where the income can grow tax-free.
Tax on $100 in Canadian eligible dividends income
Next, let’s take a look at what will happen to that $100 if John invested the principal in Canadian corporations and received Canadian eligible dividends totalling $100. Because the source of the dividend is domestic and the dividends are considered “eligible”, John will have access to a dividend tax credit, which is at 15.0198%.
To calculate tax on the $100 eligible dividend, John will first have to “gross up” the $100 by 38%. The 38% is to bring the dividend amount back up to the amount before corporate income tax. So in John’s example, it will be $100 x 38% = $138. The $138 will first be subject to the ordinary income tax rates above. The calculation is the same as the interest example, and John’s tax will therefore be $138 x 20.5% + $138 x 9.15% = $40.92 tax for the $100 dividends he earned.
That’s even worse than the $100 interest! You may say. However, there is one catch. Because John is now eligible for the 15.0198% dividend tax credit, the credit will bring his tax bill down by $138 x 15.0198% = $20.72. So the actual tax amount that John will have to pay will be only $40.92 – $20.72 = $20.20. That’s more than 30% savings vs. ordinary interest! Some provincial governments even go one step further and provide provincial dividend tax credit that can help reduce the tax even further.
Of course, should John receive ineligible dividends, the benefits will be less. In the case of foreign dividends, the dividend tax credit will be non-existent, though you do not need to “gross up” your dividends, and you may qualify for foreign tax credits.
Tax on $100 in capital gains
Finally, let’s look at capital gains. Capital gains arise when your investment increases in value, and it is only taxed when you sell the stocks. For example, if you invest in stock ABC 5 years ago at $10 a stock and it continues appreciating in value year after year, you do not have to pain capital gains tax until the year you decide to sell the investment.
Let’s see what will happen to John’s $100 if it comes in the form of capital gains. Suppose John bought one share of company X at $50, and five year later, the share has grown to $150 and he decides to sell it, for a profit of $150 – $50 = $100. The Canadian government is very generous with taxation rules around capital gains, and has stated that only 50% of the capital gains are taxable. This means that instead of adding the full $100 to John’s taxable income, he will only need to add 50% x 100 = $50. The $50 is subject to the same income tax rules, so John will have to pay $50 x 20.5% + $50 x 9.15% = $14.83 in taxes. This favourable tax rule leaves 50% more money in John’s pocket, compared to what would happen if he received the $100 from ordinary interest.
Here’s the summary of the tax bill that John will be liable for, for the same $100 earned from different savings vehicles:
|Interest||Canadian eligible dividend||Capital gains|
There you have it! I hope the explanation above is clear. In general, if you are looking to minimize tax %, remember the rule below
General rule to minimize tax % in your savings vehicles
Capital gains > dividend income > interest
Of course, minimizing tax percentage shouldn’t be the only criterion you consider when making your investment decisions and your brokerage account. You should take into consideration your time horizon, your risk tolerance, the diversification of your existing portfolio, and your after-tax return of various investments. You need more than just minimizing tax for a well-rounded decision.
That’s it for today. I hope you find the article helpful. Leave a comment below if you are interested in learning more!