How is My Investment Income Taxed?

Income from your investments can come in various forms, such as interest, dividends and capital gains, each of which is subject to a different tax treatment.

While tax implications of investment income should not normally be the main factor in your investment decisions, it's good to have an understanding of how income types are taxed within your portfolio.

Here are the most common types of income from investments:

• Interest income: Payments received for lending funds to a borrower are fully taxable at your marginal rate — the tax rate that applies to the top tier of your employment income under Canada's graduated tax system. This includes interest earned from bank accounts, guaranteed investment certificates (GICs), bonds and fixed-income mutual funds, exchange-traded funds (ETFs) and all other interest-producing investments.
• Capital gains: Profits from the sale of property or investments are taxable when realized — that is, when you sell the property or make a taxable transfer. Currently, only 50 per cent of the increase over what you originally paid is taxable at your marginal rate.
• Dividends¹ from Canadian corporations: Payments to shareholders, usually as a share of the company profits, can be designated as non-eligible or eligible dividends. Dividends are included in income at a grossed-up rate but qualify for the dividend tax credit, which reduces your total tax due. Eligible dividends qualify for an enhanced tax credit. The precise effect will vary according to your overall income and province of residence. In general, dividends are taxed at a lower rate than interest but a higher rate than capital gains.
• Dividends from foreign corporations: Dividend distributions from non-Canadian corporations are subject to different tax treatment. They are fully taxable at your marginal rate and do not qualify for a dividend tax credit. In addition, in most cases there will also be withholding taxes paid to the foreign country, the amount depending on the country and the type of account holding the shares. A foreign tax credit may be available and could reduce the tax payable in Canada on the dividend. Other particularities may apply and it is best to consult with a tax professional to fully understand tax implications of any foreign dividends you receive.
• Return of capital: When an investment such as a unit of a mutual fund trust pays a regular distribution, but the interest, dividends and realized capital gains are less than the fixed distribution amount, the difference is considered return of capital to its investors. This is not considered income and is not taxed in the year it's received. Instead, it is subtracted from the price you originally paid for the fund, which could result in a larger capital gain when you eventually sell or transfer it.

Keep in Mind:

• The types of investments you own and whether you hold them inside or outside of registered plans can have a bearing on the tax efficiency of your overall portfolio
• You should look at all the investments — both registered and non-registered — held by you and your spouse (if applicable) as one integrated "portfolio." By examining the big picture you can arrange your investments to be as tax-efficient as possible.
• You may want to ensure you're maximizing your Registered Retirement Savings Plan (RRSP), which could mean more money in retirement while paying less tax now.
• You can also consider a Tax-Free Savings Account (TFSA). While contributions are not tax-deductible, your investments will grow tax-sheltered and generally will not be taxed on withdrawal.
• When you collapse your RRSP, which must be done by the end of the year you turn 71, you can continue to benefit from tax-deferred growth by rolling the assets into a Registered Retirement Income Fund (RRIF). While you must withdraw a certain amount from the RRIF each year, income earned on amounts remaining in the plan are tax-deferred.
• Holding investments that generate fully taxable interest income in your RRSP or RRIF allows them to grow in a tax-deferred environment. Meanwhile, holding equities and equity mutual funds in your non-registered accounts allows you to benefit fully from the Canadian dividend tax credit and the preferential tax treatment for capital gains.

Find out more about taxes in the Investment & Tax Season Centre.

The information provided in this article is for general purposes only and does not constitute personal financial or tax advice. Please consult with your own professional advisor to discuss your specific financial and tax needs.